Uneasy Money

I am about to venture slightly out of my usual comfort zone, monetary theory, history, and policy to talk about taxes. You guessed it, March is almost gone, and I still haven’t filed my income tax returns. But that’s not what I am going to write about. I am going to discuss an article by Eduardo Porter (“The Case for Raising Top Tax Rates’) in today’s New York Times Business Section which caught my eye. Porter gives a good summary of the sea change in tax policy that was inspired by a brash young economist with a Ph. D. from the University of Chicago working in the Nixon and then Ford Administration in the early 1970s. His name was Arthur Laffer.  Porter tells the (apocryphal?) story of how Laffer drew his immortal curve for his bosses (Donald Rumsfeld and Dick Cheney — once upon a time able public servants!) on a cocktail napkin showing that any feasible amount of tax revenue could be generated by two tax rates (one high and one low) except for the maximum total revenue achievable only by a unique rate. The Laffer curve became the inspiration for what became known as supply-side economics. Despite enduring much ridicule, the Laffer curve became the central plank in the platform on which Ronald Reagan won the Presidency in 1980. Cutting taxes became the unifying principle on which almost all Republicans could agree, becoming the central pillar of conservative and eventually Republican orthodoxy. It was not always so. Barry Goldwater voted against the Kennedy across-the-board tax cuts of 1963. His vote against tax cuts, cuts supported by his chief opponent for the Republican Presidential nomination in 1964, Nelson Rockefeller — the object of conservative revulsion and outrage to this day — did not evoke so much as a peep of protest by conservatives when Goldwater was carrying the conservative torch in his epic campaign for the GOP nomination.

But as Porter points out, it’s not just conservative and Republican views on taxes that have changed. There was bipartisan support for cutting rates in 1986 when the top marginal rate was cut to 28%. Although Democrats consistently want to raise the top marginal rate, President Obama has not proposed raising the top marginal rate even to 40%, 10% below the 50% top rate under the Reagan tax cuts of 1981.

Why this sea change since the 1960s in views about top marginal rates? Obviously, tax cutting has proved itself to be politically popular, and that may be all the explanation necessary to account for the change in the political consensus about how high marginal tax rates can be raised. But Porter also notes that there was an important economic component in support for keeping tax rates low.

For 30 years, any proposal to raise taxes had to overcome an unshakable belief that higher taxes inevitably led to less growth. The belief survived the Clinton administration, when taxes rose and the economy surged. It survived George W. Bush’s administration, when taxes were cut yet growth sagged.

Porter cites new research suggesting that the scope for tax increases is really a lot greater than had been thought. Not only could the government “raise much more tax revenue by sharply raising the top tax rates paid by the richest Americans, but it could do so without slowing economic growth.” To support this idea, Porter cites a recently published paper by Emmanuel Saez and Nobel Laureate Peter Diamond. They argue that raising the top marginal rate to 80% would NOT cause revenue to fall if the loopholes available to the rich were closed. One obvious problem with that proposal is that the rich have a huge incentive to spend money lobbying against any increase in rates that is accompanied by closing loopholes and against any closing of loopholes not accompanied by a reduction in rates. Guess what? Spending money on Congress works, so don’t hold your breath waiting for tax rates to rise while loopholes are closed. But Saez and Diamond also estimate that even without closing loopholes the top marginal rate could be increased to 48% before any further rate increases would reduce revenue.

Moreover, in another study Saez, Slemrod and Giertz found that although the rich would respond to increases in marginal rates by trying to shelter more of their income, doing so would not cause economic growth to slow down. Porter explains:

That’s because a lot of what the rich do does not, in fact, generate economic growth. So if they reduced their effort in response to higher taxes, the economy wouldn’t suffer.

Porter adds:

The arguments are not the mainstream view. Some economists really dislike them. And they are not absolutely airtight. The calculations rely on estimates about how higher tax rates would discourage the rich from working or investing over a couple of years at most. But we know little about how they might affect long-term decisions, like whether to become a brain surgeon or a hedge fund manager. We do know that in countries with higher tax rates, like France, people work fewer hours than in the United States.

Is there any way of explaining why raising top marginal rates to very high levels would not cause a loss of real income? Here’s an idea. The era of low marginal tax rates in the US has been associated with a huge expansion in the US financial sector. Wall Street has consistently been paying the highest salaries and giving the largest bonuses ever since the 1980s, attracting the best and the brightest from each year’s new crop of grads from our elite colleges and universities. What has been the social payoff to this expansion of finance? I am not so sure. Over a century ago, Thorstein Veblen wrote his book The Theory of the Leisure Class, followed some years later by his essay “The Engineers and the Price System.” He distinguished between engineers who actually make things that people use and financiers who simply make investments on behalf of the leisure class, adding no value to society. This was a vulgar distinction, premised on the unwarranted assumption that finance is unproductive simply because it generate no tangible physical product. On that criterion, Veblen would have ranked pretty low as a contributor to social welfare. Mainstream economists felt pretty comfortable dismissing Veblen because he was presuming that only physical stuff can be valuable.

However in 1971, Jack Hirshleifer, one of my great teachers at UCLA, wrote a classic article “The Private and Social Value of Information and the Reward to Inventive Activity.” The great insight of that article is that the private value of information, say, about what the weather will be tomorrow, is greater than its value to society. The reason is that if I know that it will rain tomorrow, I can go out today and buy lots of cheap umbrellas (suppose I live in Dallas during a drought), and then sell them all tomorrow at a much higher price than I paid for them. The example does not depend on my having a monopoly in umbrellas; I sell every umbrella that I have at the rainy-day market price for umbrellas instead of the sunny-day price. The gain to me from getting that information exceeds the gain to society, because part of my gain comes at the expense of everyone who sold me an umbrella at the sunny-day price but would not have sold to me yesterday had they known that it would rain today.

Our current overblown financial sector is largely built on people hunting, scrounging, doing whatever they possibly can, to obtain any scrap of useful information — useful, that is for anticipating a price movement that can be traded on. But the net value to society from all the resources expended on that feverish, obsessive, compulsive, all-consuming search for information is close to zero (not exactly zero, but close to zero), because the gains from obtaining slightly better information are mainly obtained at some other trader’s expense. There is a net gain to society from faster adjustment of prices to their equilibrium levels, and there is a gain from the increased market liquidity resulting from increased trading generated by the acquisition of new information. But those gains are second-order compared to gains that merely reflect someone else’s losses. That’s why there is clearly overinvestment — perhaps massive overinvestment — in the mad quest for information.

So I am inclined to conjecture that over the last 30 years, reductions in top marginal tax rates may have provided a huge incentive to expand the financial services industry. The increasing importance of finance also seems to have been a significant factor in the increasing inequality in income distribution observed over the same period. But the net gain to society from an expanding financial sector has been minimal, resources devoted to finance being resources denied to activities that produce positive net returns to society. So if my conjecture is right — and I am not at all confident that it is, but if it is – then raising marginal tax rates could actually increase economic growth by inducing the financial sector and its evil twin the gaming sector — to release resources now being employed without generating any net social benefit.

UPDATE 9:39PM EDST:  I left out “not” (now in CAPS) in between “would” and “cause to fall” in the fourth sentence of the paragraph beginning with “Porter cites.”

UPDATE 9:46PM EDST:  I revised the final sentence of the same paragraph which had been unclear.

In my previous post, I pointed out that inflation (measured by both the GDP price deflator and the Personal Consumption Price Index) in the fourth quarter has fallen back to a level well below the Fed’s 2% target.  Indeed, it is running at nearly the lowest rate since the end of World War II. Later, when reading this post by Noah Smith commenting on this post by John Taylor’s (also see Taylor’s op-ed in the Wall Street Journal), it occurred to me that, viewed from the perspective of the current rhetoric about sound money and proposals to eliminate the dual mandate of the Fed and impose on the Fed a single unambiguous mandate of maintaining price stability, it is hard to understand why some people are so harshly critical of Mr. Obama’s record as President. If price stability is really the alpha and omega of monetary policy, then, based on his success in keeping inflation low, shouldn’t Mr. Obama be rated the most economically successful President in living memory?

If, despite President Obama’s stellar record in suppressing inflation – either directly or through his re-appointment of Ben Bernanke as Fed Chairman — is not enough to mollify the critics who loudly assert that the only macroeconomic objective of the Federal Reserve Board should be to ensure price stability, doesn’t that suggest that they actually care about more than price stability and that calls for the Fed to stop paying attention to anything but the rate of inflation are perhaps less than 100% sincere?  After all, inflation is lower now than it was during the administration of Ronald Reagan, and aside from his reputation as the quintessential Conservative, Reagan is also viewed as the slayer of inflation and the very paragon on a sound money man.  So I thought that it might be useful to go back and see what the Reagan administration itself had to say about inflation while it was in office.

So herewith I provide a few excerpts from the  Annual Reports of the Council of Economic Advisers published in the Economic Report of the President during the Reagan Presidency.

Economic Report of the President 1984

The tendency toward a slight increase in inflation over the year was also registered by the producer price index. Over the 6 months ending June, the index for total finished goods fell at annual rate of 0.9 percent,but over the second half of the year this index rose at 2.0 percent annual rate. Even so, inflation by this measure was lower than that in the recession phase of the cycle. The GNP implicit price deflator, the broadest measure of inflation, rose by 4.0 percent over the four quarters of the year. (p. 190)

The gradual reduction in inflation assumed by the Administration does not depend on a policy assumption that such a result will be “forced” by deliberate actions to choke off economic growth whenever there is any sign of a rise in inflation. Rather, the decline in inflation is the anticipated outcome of the assumed steady and predictable monetary and fiscal policies. As with real growth, it is expected that inflation may sometimes be higher and sometimes lower than the Administration assumption, but that the trend will be downward as indicated. (p. 199)

Economic Report of the President 1985

Although it is common for inflation to fall somewhat during the early stages of business cycle recoveries, few observers anticipated that the inflation rate would remain so low during a recovery as rapid as that experience in 1983-84. The inflation rate rose slightly in the second half of 1983 and early 1984, but there was no apparent tendency for the rate to rise further. Indeed, over the course of 1984 the inflation rate declined somewhat. However, inflation is still higher than desireable, and it worth noting that the services component of the CPI in 1984 showed some signs of slightly rising inflation. (p. 44)

The inflation outlook for 1985 is good. With moderate expansion in the money aggregates and continuing real growth, the inflation rate, as measured by the GNP deflator, is expected to average 4.3 percent over the four quarters of 1985. (p. 62)

Economic Report of the President 1986

After being lower than expected in 1985, the inflation rate, as measure by the GNP deflator, is expected to rise somewhat in 1986. Rapid monetary growth throughout 1985 as well as the depreciation of the dollar are expected to place upward pressure on prices. The projected rise in near-term inflation, however, is expected to be temporary, provided that a policy of gradual money-growth reduction is pursued. (p. 23)

The unsatisfactory economic performance associated with the rise of inflation and the adjustment problems that arise during disinflation provide a clear lesson: reacceleration of inflation must prevented. The surest way to avoid the costs of both inflation and disinflation is to avoid the policies that lead to an acceleration of inflation. Moreover, the experience of the past 3 years has indicated that substantial economic growth can occur without rekindling inflation. (p. 70)

Economic Report of the President 1987

More than 4 years of economic expansion, with the inflation rate remaining near or below 4 percent and interest rates declining to their lowest levels in 9 years, have laid te foundation for sustainable real growth with moderate inflation. (p. 19)

The inflation rate is 1987 is forecast to return to the 3.5 to 4 percent range of recent years, before the decline in oil prices temporarily depressed the inflation rate in 1986. Specifically the GNP deflator is forecast to rise at a 3.6 percent annual rate during 1987, after a 2.2 percent rate of increase during 1986. (p. 58)

Economic Report of the President 1988

Higher oil prices and higher import prices increased the 1987 inflation rate (as measured by the CPI) above the very low rate recorded in 1986. Higher import prices also are expected to contribute to consumer price inflation in 1988. However, after a year of slow growth of monetary aggregates, and in view of the expected slowing of real economic growth, acceleration of inflation is not seen as a likely danger in 1988. On a fourth-quarter to fourth-quarter basis, the CPI is forecast to rise 4.3 percent in 1988, a small decline from the rise in 1987. The GNP deflator, which is not affected directly by import prices, is forecast to rise 3.9 percent in 1988. (pp. 48-49)

Economic Report of the President 1989

An important legacy of this Administration is the refocusing of economic policy. The Administration deemphasized short-run stabilization policies; worked to provide a stable policy environment with market-based incentives for productive behavior, including low inflation; and attempted to extricate private markets from burdensome regulations. The strength and durability of the current expansion bear testimony to the soundness of these policies. In December 1988, the current economic expansion entered its seventh year, making it the longest peacetime expansion and the third longest on record. Most impressively, the inflation rate has not risen during this expansion, but has remained in the neighborhood of 3 to 4 percent. (pp. 258-59)

So it seems that President Reagan and his economic advisers thought that they were doing well to keep inflation at 4 percent a year.  Sure, they would have liked to get the inflation rate down a  bit, but they weren’t prepared to risk even a slowdown in the rate of decrease in unemployment to reduce inflation, much less tolerate any increase in the unemployment rate.  Promised reductions in the rate of inflation below the steady 3.5-4% rate that prevailed for the most part after the recovery started in 1983 just kept getting deferred further and further into the future.  Is that a record that John Taylor would like the next President of the United States to emulate?

UPDATE (01/25/12):  This post is erroneous and none of its conclusions should be relied upon.

OK, so it has come down to this.  I just asserted that the way to translate Lucas and Cochrane into the Keynesian model is to set the mpc equal to zero.  In that case, any increase in government spending that is offset by taxes causes no net increase in income, because as, Lucas puts it, the increase in government spending is exactly offset by a decrease in consumption of an equal amount thanks to the reduction in after-tax income.  This exercise is predicated on the assumption that the equal increase in government spending and taxes is permanent.  But in the exercise proposed by Wren-Lewis, the increase in government spending is temporary and the increase in taxes is also temporary.  How does the transitory nature of the increase in government spending and taxes alter the analysis under a Lucasian version of the Keynesian model?

Wren-Lewis claimed that you get a stimulative effect.  The increase in government spending is concentrated in the present, but the reduction in spending is spread out over the future, leaving a net positive effect in the current period.

Thanks to Scott Sumner’s comment on my previous post (which I too confidently pronounced definitive), I now see where Wren-Lewis and the rest of us went wrong.  The stimulative effect of the government spending is depends on the existence of a simple multiplier greater than 1 (i.e., an mpc greater than 0) [This is in error, a stimulative effect is present for any value of the MPC less than 1 for which a unique equilibrium exists in the simple Keynesian model.].  So to say that government spending must be stimulative, even if offset by taxation, begs the question whether government spending generates any increase in income beyond the amount of initial spending.  If you assume fully rational maximizing on the part of households (Ricardian equivalence), their mpc is equal to 0 (though that may perhaps be subject to some quibble, in which case there would still be room for argument on the effect of tax-financed government spending).  [The balanced budget multiplier is 1 in the simple Keynesian model even if the MPC equals 0.]

But if you are willing to grant for the sake of argument that the mpc is equal to 0, then it does seem that even a temporary increase in government spending would imply no net increase in income because of the absence of multiplier effects.  The increase in government spending would be offset by an equal decrease in consumption spending caused either by 1) increased taxes today or 2) by increased saving today in the expectation of future tax payments.  (I am now a bit troubled that this doesn’t seem to accord with Nick Rowe’s analysis, but I will  have to live with that until he weighs in again on the subject.)  [I should have realized that I was confused at this point and started over.]

Note that I didn’t need to say anything about accounting identities to get to this result.  (Gotta find that silver lining somewhere.)  But Scott can still feel good about having convinced me that his basic intuition was right.  The should teach us all to remember the old maxim, “Don’t Mess with Scott.”

PS At this stage, I am fully prepared to be proven wrong yet again, so I will be reading your comments very carefully to find the next surprise lying in store for me.

I rarely venture beyond the narrow confines of macroeconomics, monetary theory and monetary policy on this blog, and I am not planning to change that focus.  But it’s my blog, so I get to write about whatever I choose to.  How’s that for libertarianism in action?  At any rate, I just read an excellent essay on energy policy by William Nordhaus of Yale (“Energy: Friend or Enemy?” in the New York Review of Books, 10/27/11), not the least of whose many accomplishments was being chosen by Paul Samuelson as co-author of later editions of Samuelson’s legendary principles textbook (a wonderful textbook, but not the best economics textbook ever written.) Nordhaus’s essay is structured around a review of two new books The End of Energy: The Unmaking of America’s Environment, Security and Independence by Michael J. Graetz, and Hidden Costs of Energy: Unpriced Consequences of Energy Production and Use a report by the National Research Council’s Committee on Health, Environmental, and Other External Costs and Benefits of Energy Production and Consumption. National Academies Press (available for free at http://www.nap.edu).

Rather than try to summarize Nordhaus’s essay, I will just mention what seem to me to be the two most important points. First, all the major sources of energy now used in the US, (petroleum, natural gas, and coal) are associated with significant external effects (aka externalities), causing damage to property and injury to the health and well-being of individuals as well as contributing to global warming. Nordhaus cites estimates from Hidden Costs of Energy that if taxes on sulfur, carbon dioxide and other pollutants were imposed at levels corresponding to the damages caused, $300 billion a year in additional revenue would be raised. (Nordhaus doesn’t say what assumptions were made about the effect of taxation on the amount of pollution generated. If the estimates assume no reduction, less than $300 billion in revenue would be raised.)  And these estimates include only taxes on electricity generation, transportation, and heat production, leaving out other industrial and commercial uses of energy.

To put the $300 billion a year estimate in perspective, consider that the recent ill-fated Congressional super-committee was charged with reducing federal deficits by $1.5 trillion over 10 years. Thus, taxing pollution would generate (subject to the qualification mentioned in the previous paragraph) about twice as much deficit reduction as Congress agreed, but failed, to implement. Insofar as taxing pollution would lead a reduction of pollution, there would be further long-term budgetary benefits by reducing future expenditures on medical treatment for illnesses and diseases caused by pollution as well as avoiding income (and tax revenue) losses associated with those illnesses and diseases. “Environmental taxes,” Nordhaus observes,

can play a central role in reducing the fiscal gap in the years to come. These are efficient taxes because they tax “bads” rather than “goods.” Environmental taxes have the unique feature of raising revenues, increasing economic efficiency, and improving the public health.

Nordhaus sums up our dysfunctional energy-policy paralysis in a truly depressing paragraph.

In reality, U.S. energy policy has largely shunned environmental taxes in favor of environmental regulation. Virtually every proposal for an energy tax from Nixon to Obama was defeated in Congress. By way of explanation Graetz writes, “We have eschewed taxes and instead employed virtually every other policy too imaginable. Handing out tens of billions of dollars in subsidies annually is far more seductive to politicians.” And many of these subsidies mainly serve as tax shelters. Graetz quotes Congressman Pete Stark: “They are not wind farms; they are tax farms.”

Instead of raising taxes on energy to match the full costs of producing and using energy, we have engaged in an endless series of ad hoc regulatory interventions supposedly designed to reduce energy consumption and dependence on foreign oil. CAFE standards require car manufacturers to meet minimum average fuel economy standards on passenger cars. Do CAFE standards reduce fuel consumption? Perhaps they do, but not necessarily. Increasing average miles per gallon of new cars reduces the marginal cost of driving those cars, so the number of miles they are driven increases as a result. If the percentage increase in miles driven exceeds the percentage increase in miles per gallon, the net effect is an increase in fuel consumption. On the other hand, if you tax gasoline consumption, you raise the marginal cost of driving (at least compared to the cost if there is no tax), so fewer miles would be driven than with no tax on gasoline.

The second important point made by Nordhaus is the unity of the world oil market. The unity of the world oil market makes the very concept of national energy independence, to which every administration since the Nixon administration has paid foolish lip service, a snare and a delusion.

We can usefully think of the oil market as a single integrated world market – like a giant bathtub of oil. In the bathtub view, there are spigots from Saudi Arabia, Russia, and other producers that introduce oil into the inventory. And there are drains from which the United States, China, and other consumers draw oil. Nevertheless, the dynamics of the price and quantity are determined by the sum of these demands and supplies, and are independent of whether the faucets are labeled “US,” “Russia,” or “China.” In other words, prices are determined by global supply and demand, and the composition of supply and demand is irrelevant. . . .

This means crude oil is fungible, like dollar bills. A shortfall in one region can be made up by shipping a similar oil there from elsewhere in the world. U.S. oil policies make no more sense than trying to lower the water level in one end of the bathtub by taking a few cups of water from that end.

We know that the world oil market is unified because there is a single price of crude oil that holds no matter what the source. For example, we can look at whether prices (with corrections for gravity and sulfur) in fact move together. . . . A good test of this view would be to ask whether a benchmark crude price predicts the movement of other prices. Looking at crude oil from 28 different regions around the world from 1977 to 2009, I found that a 10.00 percent change in the price of “Brent” crude oil – a blend of crude often used as a benchmark for price – led to a 9.99 percent change in the prices of other crude oils. . . .

The implication of the bathtub view is profound. It means that virtually no important oil issue involves US dependency on foreign oil. Whether we consider pollution, macroeconomic impacts, price volatility, supply interruptions, or Middle East politics, our vulnerability depends upon the global market. It does not depend upon the fraction of our consumption that is imported.

Nordhaus is undoubtedly correct in emphasizing the bathtub view. However, he may be overstating the case just a bit. Over the past couple of years, and especially in 2011, the spread between WTI and Brent crudes, which for years was almost nil, has widened to an extraordinary extent, approaching $30 a barrel in July and still remaining close to $10 a barrel.  See the chart below.

Nordhaus argues that the bathtub theory implies that imposing sanctions or an embargo on Iranian oil exports would be futile, but I suspect that although an embargo on Iranian oil exports could not cut off Iranian oil exports from the world market, it could impose a real hardship on Iran, reducing its income from oil exports by some non-negligible amount, quite likely at least 5-10%, though probably less than 25%. But I am just quibbling about a detail, an important detail to be sure, but still a detail. If you want to understand energy policy and how it fits in with other aspects of economic policy, read what Nordhaus has to say.

Sorry to have to do this, but I discovered a serious error in the table in my post from August on the European crisis.  I have inserted a new revised table correcting and updating the growth rates in the eurozone countries since 2008 and 2009.  I had hoped to post something new on the European crisis before Thanksgiving, but I have been struggling to correct and update the old table before I could get around to writing up something new on the European situation.  Perhaps I’ll have something ready over the weekend.  Again, my apologies.

John Taylor has had a long and distinguished career both as an academic economist and as a government official and policy-maker.  He is justly admired for his contributions as an economist and well-liked by his colleagues and peers as a human being.  So it gives me no pleasure to aim criticism in his direction.  But it was pretty disturbing to read Professor Taylor’s op-ed piece (“A Slow-Growth America Can’t Lead the World”) in today’s Wall Street Journal, a piece devoid of even the slightest attempt to make a reasoned argument rather than assemble a hodge podge of superficial bromides about the magic of the market and the importance of fiscal discipline and sound monetary policies.  It is almost surprising that Taylor failed to mention motherhood, apple pie, and American flag while he was at.  Even more disturbing, Taylor proceeds, with no hint of embarrassment, to trash the half-hearted attempts by the Federal Reserve to use monetary policy to promote recovery even though the Fed’s policies are similar to, though much less aggressive than, the “quantitative easing” that he applauded the Japanese government and the Bank of Japan for adopting from 2002 to 2004 to extricate Japan from a decade-long period of deflation and slow growth starting in the early 1990s.

Taylor begins by attacking President Obama’s policies, strongly suggesting that those policies are responsible for the weak economic recovery.

At the most recent [G-20] meeting a year ago in Seoul, the G-20 rejected [President Obama’s] pleas for a deficit-increasing Keynesian stimulus and instead urged credible budget-deficit reduction and a return to sound fiscal policy.  And on that trip he had to defend the activist monetary policy of the Federal Reserve against widespread criticism that its easy money was damaging to emerging-market countries, causing volatile capital flows and inflationary pressures.

With a weak recovery – retarded by new health-care legislation and financial regulations, an exploding debt, and threats of higher taxes – the U.S. is in no position to lead as it has in the past.

Taylor then invidiously compares Obama’s failure in Seoul with the good old days after World War II when America called the shots.

By contrast, in the years after World War II, the U.S. led the world in promoting economic growth through reliance on the market and the incentives it provides, the rule of law, limited government, and more predictable fiscal and monetary policy.

This tendentious characterization of post-war economic policy overlooks the many sectors of the US economy then subject to strict regulation of prices and other aspects of their business operations, the powerful position of labor unions, and top marginal income tax rates as high as 92%, falling to 70% only after the Kennedy tax cuts were enacted in 1964.  High marginal tax rates and powerful labor unions were the norm in all developed countries in the 1950s and 1960s, so economic reality was far from the free-market utopia one might have imagined based on the comic-book picture offered by Taylor.  But that comic-book picture inspires Taylor to draw the following grand geopolitical lesson from the history of the last 65 years. 

As the U.S. has moved away from the principles of economic freedom – instead promoting short-term fiscal and monetary interventionism with more federal government regulations – its leadership has declined.  Some, even in the U.S., may cheer the decline, but it is not good for the world or the U.S.

Warming to his area of special expertise, monetary policy, Taylor continues by expounding on the evils of “monetary interventionism”

In the case of monetary policy . . . decisions on interest rates by foreign central banks are influenced by interest-rate decisions at the Federal Reserve because of the large size of the U.S. economy.  If the Fed holds its interest rate too low for too long, then central banks in other countries will have to hold rates low too, creating inflation risks.  If they resist, capital flows into their countries seeking higher seeking higher yields, thereby jacking up the value of their currencies and the prices of their exports.

But Professor Taylor has not always taken such a negative view of “monetary interventionism.”  In 2006, he wrote a background paper for the International Conference of the Economic and Social Research Institute Cabinet Office of the Government of Japan (September 14, 2006) entitled (I swear) “Lessons from the Recovery from the “Lost Decade” in Japan:  The Case of the Great Intervention and Money Injection.”

Describing his involvement in 2001, while Under-Secretary of the Treasury for International Affairs in the Bush Administration, in the formulation and execution of Japanese monetary policy, Taylor writes:

[I]n March 2001, the Bank of Japan announced that it would follow the new type of monetary policy, which it called “quantitative easing” and under which it would pump up the money supply in Japan until deflation ended.  I was ecstatic when I heard this announcement.  Since 1994 I had been an adviser to the Bank of Japan, a position I had to resign from when I joined the Bush Administration and I had recommended many times that the Bank of Japan focus on increasing the money supply as a means to end their deflation, and many other economists had recommended the same thing.

Now it’s true that inflation in the US as measured by the CPI has been running in the 3-4% range over the past year, but average inflation over the past 3 years has averaged only about 1% and expected inflation over a two-year time horizon has been consistently below 2% for the last year.  So the recent rise in inflation seems to be a transitory phenomenon while GDP growth remains very slow and unemployment very high.  With inflation, after a short blip, again falling and expected to remain very low for years, it is not at all clear that our situation is much different from the situation in Japan in 2001.  Yet Taylor wrote in 2006 that he had been ecstatic when he heard that the Bank of Japan “would pump up the money supply in Japan until deflation ended,” while now protesting his unqualified opposition to a not entirely dissimilar, though certainly less aggressive, policy by the Federal Reserve.

Taylor goes on to describe how the Japanese exited from their “monetary intervention.”

During the fall and winter evidence of a sustainable recovery in Japan mounted, and I thought that the sooner the recovery became clear, the soon Japan could exit from its intervention.  On December 5, 2003, I gave a speech in New York asserting that Japan was on the road to recovery.  It was still a little risky to declare victory that early, but fortunately I was right and the economy had indeed turned the corner.  Michael Phillips of the Wall Street Journal  wrote a piece entitled “U.S. Sees Reason to be Optimistic on Japan Growth” on the morning of my talk saying:  “The Bush Administration believes the Japanese economy may finally have turned the corner after more than a decade of little or no growth.  In a speech to be delivered today, the Treasury Department’s top international official, John Taylor, will credit the Koizumi government’s market changes and the Bank of Japan’s accommodating monetary policy for giving impetus to the country’s laggard economy. . . The upbeat comments from the Undersecretary of the Treasury for International Affairs represent a sharp shift in Washington’s long pessimistic view of Japan’s fortunes.”

In today’s Journal, however, the possibility that “monetary intervention” could give “impetus the [U.S]’s lagging economy” seems never even to have crossed Professor Taylor’s mind.

Some countries . . . are complaining that the Fed is exporting inflation with its near-zero interest rate and massive purchases of long-term government debt. . . And when global inflation picks up, as it has started to do in many emerging markets, it feeds back into more inflation in the U.S. through higher prices of globally traded commodities.  With unemployment already high, the result would be stagflation – slow growth, high inflation, steady unemployment – as we saw in the 1970s.

I guess we are just supposed to forget, along with Professor Taylor, about “accommodating monetary policy giving impetus to the country’s laggard economy.”  Oh my what a difference four or five years make.  Things do change, don’t they?

HT:  Benjamin Cole