When stagflation engulfed the U.S. in the late 1970s and early 1980s, policymakers responded with what Nobel Prize-winning economist Robert Mundell called a fiscal/monetary policy mix. The right medicine for stagflation was tight money and a stronger dollar to push down inflation and high interest rates and lower marginal tax rates to boost the “real” side of the economy. Today, the U.S. needs a policy mix that prevents deflationary pressures on the monetary or demand-side, and lower tax rates on capital and labor to boost private-sector growth on the supply-side.
Between 1996 and 2001 the U.S. dollar appreciated by more than 30% against gold, commodities, and foreign exchange. The rise in the value of the dollar pushed U.S. monetary policy past the point of price stability and into monetary deflation, placing undo strain on dollar debtors.
At first, the producers of intellectual goods enjoyed a temporary euphoria at the expense of old economy, commodity producers. Countries that had dollar-linked currency pegs and commodity-dependent GDPs paid dearly for this lopsided boom. While the so-called tech bubble was inflating on one side of the economy, the commodity, basic-material, old economy was deflating.
As deflationary pressures went unabated, nominal growth decelerated, economy-wide pricing power vanished, and profits collapsed. This prompted the tech wreck and an implosion in capital goods spending. The so-called bubble burst.
With the price of gold over $350 an ounce, commodities rising, and the dollar falling against foreign exchange, deflationary pressures now are unwinding. Unfortunately, the fall in the dollar largely has been the result of growth-negative forces. Higher state and local tax rates, a slightly higher tariff wedge, a less growth-friendly regulatory structure, elevated levels of geo-political risk, and the on-going costs of the war on terrorism have all contributed to the decline of the dollar. This is a costly way to undo deflation.
After 525 basis points of interest-rate cuts by the Federal Reserve and tax cuts on the federal level, nominal growth remains weak, risk spreads remain at historically wide levels, and profits (as measured by the GDP accounts) have contracted for three consecutive quarters and likely will end 2002 in negative year-over-year territory. As a direct consequence, private-sector payroll employment has fallen by 1.75 million as firms attempt to bring costs into line with revenues. The broadest measure of wealth — household net worth — has collapsed by more than $3 trillion over the last three years from a high of $42 trillion in 1999. This is the first three-year decline in post-war history. Deflation has taken its toll.
For each policy goal, there must be a policy lever. Avoiding deflation and inflation requires a monetary lever, based on “forward-looking information,” as Fed Governor Edward Gramlich noted in a recent speech on the need for a monetary anchor. The most monetary commodity in the dollar universe is the price of gold, which lays at the intersection of dollar supply and dollar demand. Because there is so much above-ground gold in the world relative to its annual consumption and production it — more than another other commodity — provides a real-time reference point for monetary policy.
In order to prevent deflation from creeping back into the financial system, the Fed should set its over-night interest-rate target aside and target a stable value for the dollar. It could do this by stabilizing gold near the $350 level. An alternative approach would stabilize the value of the dollar in a 10% band against the CRB commodity index near the 300 level, although this approach would be inferior to a gold link, as gold leads other commodities and thus is the most useful forward-looking anchor for policy.
More than anything else, fixing the value of the dollar against a stable, real-time price-level indicator would allow the Fed to meet the demand for dollar liquidity without erring on the side of deflation or inflation. Short-term rates should be allowed to find their own level as determined by the market.
Providing the backdrop for capital formation, risk-taking and rapid growth also requires a fiscal lever. To achieve this, Congress should embrace President Bush’s proposal to eliminate the double-taxation of dividends and accelerate the 2001 reductions in marginal income-tax rates. Republicans could compromise by adopting the Democratic measure to block grant money back to the states so that state and local tax hikes do not continue to counteract federal stimulus.
Scrapping the double taxation of corporate dividends would end the current tax-code bias toward debt and away from equity. It also would drop the maximum effective tax wedge on capital to 35% from over 70% today. This would boost the after-tax rate of return to capital, enhance the capital-allocation process, and raise the capital/labor ratio. Real growth and real wages would rise.
According to Gary Robbins at Fiscal Associates, when these dynamic effects are taken into consideration, this reform alone could add $280 billion in constant dollar output to the economy against a static cost of around $70 billion.
A stable dollar policy is required to anchor the price level while lower tax rates are needed to boost growth. This kind of policy mix easily could add two points to the long run potential growth rate of the U.S. economy. A two-percentage point difference in the growth path of nominal GDP over a 10-year period, for example, would be equal to a $2.7 trillion difference in cumulative tax-revenue collections.
Budget surpluses are the result of rapid growth, not the cause of it. Once the U.S. economy is back on the growth track, the debate about budget deficits will once again morph into a fight over burgeoning surpluses. The fix is in the policy mix.
— Michael T. Darda is chief economist of Polyconomics Inc., a macroeconomic research firm located in Parsippany, New Jersey.