To: SSU Students
From: Jude Wanniski
Re: President Clinton’s Economic Record
In his speech to the Democratic National Convention on Monday night, President Clinton spoke of his record in managing the national economy. He most emphatically took credit not only for the size and shape of the current economic expansion, but also magnified his achievement by characterizing the economy he inherited in 1993 as an abysmal one: “Our economy was in trouble, our society was divided, our political system was paralyzed. Ten million of our fellow citizens were out of work. Interest rates were high. The deficit was $290 billion and rising. After 12 years of Republican rule, the federal debt had quadrupled, imposing a crushing burden on our economy and our children.”
Mr. Clinton went on to describe how he had brought about this astonishing modern miracle: He raised taxes. He didn’t put it that way, but the whole burden of his argument was placed on the 1993 tax act, which increased the top marginal income-tax rate to 38% from 31%. Here is how he put it: The “new economic strategy [was to]: Get rid of the deficit to reduce interest rates, invest more in our people and sell more American products abroad.”
If this is true, the policy fits no recent conventional economic theory. Faced with high unemployment, the Keynesian economics of the 1930s called for raising taxes on the rich, who were not spending fast enough, in order to increase spending by government. There is nothing in the economic literature that suggests Keynes wanted to raise taxes to lower the existing deficit in order to lower interest rates. The neo-Keynesians who have advised the Clinton administration, including Treasury Secretary Lawrence Summers, never held that the 1993 tax increase would expand the economy, although they did believe it would lower interest rates if Federal Reserve chairman Alan Greenspan accommodate the tax increase with lower interest rates.
What really happened is that at the moment the tax increase passed the Congress in September 1993, without a single Republican vote, the 30-year government bond was at its low point, 5.78%. In the seven years since then, interest rates have been HIGHER than 5.78% and only in recent weeks have they returned to that level and are now marginally lower, at 5.70%. Yet the President asks us to believe, and apparently has persuaded himself that it is true, that his tax increase of 1993 was the foundation of the expansion that followed. Insofar as Vice President Albert Gore shares in the “credit” for this new economic theory, he will be burdened by the same national disbelief Mr. Clinton faced in 1994 when the electorate turned thumbs down on his first two years by giving the Republicans control of Congress. As the Democratic convention continues this theme, we observe Gore falling further behind George W. Bush in the polls instead of getting the “bump” on which he has been counting.
Here, in our supply-side model, is how the Clinton years unfolded. By the way, when the Clinton tax increase was adopted, we were not among those Republicans who argued it would cause great difficulties for the economy, although we counted it a net negative. Our published contemporaneous record of client letters and correspondence supports this review:
1. The Clinton tax increase of 1993 caused a relatively small decline in economic expectations. This produced a decline in the demand for bank reserves -- one aspect of dollar liquidity. The price of gold, which had been fluctuating around $350 since 1985, began a rise that ended at roughly $383, a 10% increase. This is because the Fed essentially accommodated the tax increase by not subtracting the liquidity in surplus, which only can be done by selling interest-bearing bonds from the Fed’s portfolio for non-interest-bearing dollars -- “Federal Reserve notes.”
2. It was this small inflationary impulse that halted the decline in the 30-year Treasury bond and sent up interest rates. The error, small as it was, had great consequences, because many other countries had come to rely upon the stable dollar (@$350 gold). When gold rose to $383, those countries using the dollar as the benchmark for their monetary operations had to increase liquidity in order to prevent their currencies from appreciating. That is, they had to inflate along with us. As it turned out, Thailand was the most important of these countries.
3. The bank of Thailand thus had to provide more liquidity to its banking system than the banks were asking. The banks then had to lend the surplus to borrowers who were not credit-worthy, in that they had no collateral to support the loans. The loans went into brick-and-mortar projects such as shopping malls, warehouses, and housing tracts.
4. In November 1994, the Republicans got control of Congress, but for two years there was stalemate in the government as House Speaker Newt Gingrich was outmaneuvered by the White House. The Federal Reserve had tried to arrest the inflationary impulse created by the 1993 tax increase by raising overnight interest rates several times, but such moves had no net effect on liquidity and the gold price remained stuck at $383.
5. In November 1996, the voters re-elected Clinton, but again without a clear majority of popular votes. They also allowed the GOP to retain control of Congress, with more strength in the Senate -- where the new Majority Leader, Trent Lott, showed a willingness to share governance with Clinton, but with a slightly smaller majority in the House, a punishment to Gingrich. The leadership of both parties correctly read the mandate for bipartisanship in dealing with budget and tax issues. House Majority Leader Dick Armey announced “a window of opportunity” for such action.
6. The euphoria in the markets was felt as expectations of such opportunity showed up in an increase in demand for dollar liquidity. That is, the exchange economy would need more dollars than were in the monetary base. When the Fed did not supply the demanded liquidity, the price of gold began its descent from $383. By year’s end, it was down to $360. I began to warn Alan Greenspan that he should begin worrying about deflation.
7. Remember Thailand? As the dollar began to strengthen, the Bank of Thailand had to withdraw liquidity from the Thai banking system in order to prevent the baht from “weakening.” Because there were no parallel prospects for tax cuts in Thailand, the result was pure deflation. The market for all that new brick-and-mortar dried up and the developers, having no collateral to lose anyway, began turning over the illiquid assets to the banks. When the dollar gold price dropped as low as $330 or so, at midyear, the Bank could no longer maintain the dollar/baht rate and devalued the currency. The International Monetary Fund urged a bigger devaluation and tax increases. The Thai economy spun into crisis and Thai businessman began shutting off orders all over Southeast Asia. The “Asian flu” was spreading.
8. The dollar deflation did not damage all of the U.S. economy, only those parts built around commodities. This is primarily because the deflation was the result of the tax cuts, which passed the Congress and were signed into law in the summer of 1997. The Clinton team does not cite these tax cuts because they were forced on the Democratic administration by the Republican Congress.
9. The most important was the cut in the capital gains tax rate, to 20% from 28%.The Democrats had fought a lower capgains tax back to the Carter administration. In 1986, they insisted on an increase to 28% in the capgains tax in exchange for the reduction in marginal income tax rates to 28% from 45%. Supply-siders had argued throughout that the tax crippled entrepreneurial capitalism, especially when coupled with inflation, which increased the nominal rate of capgains by the annual inflation rate.
10. The other GOP measures passed in 1997 included an increase in the estate-tax exemption and the Roth IRA, both of which lifted barriers to capital formation that fueled productivity, drove up the equity markets, and encouraged business startups at a record pace. These GOP initiatives relentlessly chipped away at an unemployment rate over 6% that the Clinton economists originally said could not be lowered, as it was a “natural” rate of employment. In other words, there was no Clinton theory that could get unemployment below 5% without inflation.
11. The Greenspan monetary deflation crushed commodity producers, the independent oil industry, farmers and the communities that served them. As we pointed out during the deflation, there were benefits to other Americans. The nominal capital-gains tax, for example, was also the real rate, at the market did not have to add in a decline in the purchasing power of the dollar relative to gold and other commodities. In other words, the hard-money policies for which the supply-siders had been arguing was achieved, and over-achieved.
12. The Clinton administration deserves credit for standing behind Greenspan in squeezing out the inflation, but it was oblivious to the Fed’s overkill that bankrupted small farmers and commodity producers at home and impoverished commodity producers in the poorest nations of the world. The GOP consensus in Congress shares in the credit for the former and the blame for the latter.
13. The result of this obliviousness about the nature of monetary deflation is the energy problems we now face. For the two years 1997-1998, the world energy industry stopped exploring and producing because the Fed’s overkill sent the dollar oil price below $10 a barrel, a price which could produce no investment returns. For at least the next year or two after President Clinton leaves office, the nation and the world still will be recovering from those errors.
14. In the most generous case that can be made for the Clinton years, there was no resumption of monetary inflation that was characteristic of the Carter years, when the gold price tripled in four years as the Carter Treasury tried to expand the economy by weakening the dollar. The President also was wise enough after his first two years -- after being repudiated by the national electorate -- into giving ground when Republicans showed more skill in pressing for their tax cuts.
15. Both political parties have acted positively in dealing with the New Economy, which has been a significant part of the economic expansion. The New Economy owes much, though, to the early supply-side policies of the Reagan administration, even to the capital-gains tax cut of 1978, inspired by the late Rep. William Steiger, Republican of Wisconsin. This was the time of conception for what eventually became the Internet. Equity capital was critical to the early growth and it could not have occurred with high capgains rates plus inflation.
In his August 16 column in the NYTimes, "Still a Baby Boom," neo-Keynesian Ph.D. economist Paul Krugman addressed himself to the same question we discuss in this lesson. Who deserves credit for this long expansion? With the same assumptions employed by Mr. Clinton, Krugman comes to roughly the same conclusions: "Our soaring productivity didn't come out of thin air; an important, perhaps crucial ingredient was an amazing surge in business investment, especially in information technology. And this surge didn't have to happen. In a full-employment economy like that of America in the late 1990's, budget deficits mean that the government is borrowing money that would otherwise have been invested. This drives up interest rates, depresses asset prices and crimps business plans. Had Mr. Dole's tax cuts been enacted, the resulting deficits would surely have crowded out a lot of investment -- and quite possibly have crowded out the productivity boom."
There is nothing here about the monetary deflation and the GOP-inspired tax cuts of 1997. As a result, Krugman is forced to conclude that if the Democrats he supports are to get credit, the tax increase of 1993 must be responsible for the boom. Completing that thought, he also is forced to conclude that the Dole tax cuts as promised in his unsuccessful 1996 campaign would have increased the federal deficit, thus “crowding out” private investment. The “crowding out” argument is one of the more pernicious arguments used by the conservative economists of the 1930s in advising the Roosevelt administration to raise taxes. It assumes a fixed pool of capital, which means if the government “borrows” from it to finance the deficit, there is less capital left in the pool for private borrowers. The static concept is typical of the neo-Keynesians, who also reject the idea that lower income-tax rates -- which is what Dole proposed -- can create a fresh combination of capital and labor that did not previously exist.
This hoary “crowding out” concept fueled the Great Depression as Roosevelt used it to raise income-tax rates and capital-gains taxes to stratospheric levels. The Democrats now have come full circle as the idea is now part and parcel of the economic platform of their presidential nominee, Al Gore. It is now the inescapable conclusion that if the economy were now to weaken, and a deficit emerge as revenues declined, he would propose a tax increase to “replicate” the Clinton boom.