Don't expect monetary policy to offset other mistakes

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“All happy families are alike; each unhappy family is unhappy in its own way.” - Leo Tolstoy, Anna Karenina

A new book, with an introduction by Steve Forbes, offers a refreshingly simple model (low taxes/ stable money) for economic policy makers. The Magic Formula, Nathan Lewis,
2019. (Note: Your faithful scribe penned the first review posted for this book; please consider giving it a “helpful” vote if you feel so inclined.) Further discussion follows.

I. Low taxes - This doesn’t mean zero taxes, as governments perform functions that must be paid for, and there is no clear dividing line between “low” and “high” taxes. Furthermore, the basic fiscal problem is often wasteful government spending, which fuels demands for tax increases and/or deficit spending, versus high taxes per se. So one might arguably substitute “responsible budgeting” for “low taxes” in the formula, although – as Mr. Lewis points out – there are good reasons to beware tax increases proposed as a means of balancing the budget.

As famously depicted by the Laffer Curve, tax increases typically produce less additional revenue than hoped for. Indeed, a reduction in tax revenue may result in some cases. Also, certain types of taxes – for example, steeply “progressive” taxes (which foster tax avoidance), double taxation (e.g., tax on both corporate profits and dividends), tax on phantom income (e.g., inflation component of capital gains), and taxes that are burdensome to comply with and administer (e.g., inheritance taxes) – are justifiably resented.

It may well be possible to cut taxes in some cases, as was done under JFK, Reagan, Bush 43 and most recently Trump, without materially impairing the government’s overall fiscal position. SAFE had a mixed view of the Trump tax cuts, but supported this package as a step in the right direction while opposing tax increases. Mid-term issues: taxes,

II. Stable money – This is a more difficult concept to grasp than low taxes. The central bank mechanics are not familiar to most of us, and some of the parameters defy precise measurement.

Stable money can’t mean complete price stability, as prices for specific goods and services – which are determined by supply and demand - change all the time in a large and complicated national economy (let alone the even larger and more complicated global economy).

Overall price stability for a basket of goods and services that consumers need/want is closer to the mark, but defining that basket and measuring the cost thereof over time is no easy matter. Take the US government’s procedures for developing a Consumer Price Index (CPI) as a measure of general inflation.

One school of thought is that the CPI as periodically revised understates the real rate of inflation in the US economy. An economic reality check: part 2, inflation,

Walter J. (“John”) Williams, a Dartmouth-trained economist, has had a professional interest in the quality of government statistics for decades. He publishes alternative CPI indices based on (A) calculation procedures used in 1990 (indicating a current inflation rate of about 5%), and (B) calculation procedures used in 1980 (current inflation rate of about 9%). Shadow Government Statistics,

Here's an updated chart shadowstats chart, which continues to show that the official inflation rate is being understated.

Screen Shot 2019-06-22 at 2.22.24 PM

Others see the inflation rate as overstated because the value of technology advances is not, and perhaps cannot be, properly reflected in the CPI data. The Federal Reserve is flying blind on inflation, Andy Kessler, Wall Street Journal, 5/12/19.

I’m convinced that all of the common measures [of inflation] overshoot by at least 2 percentage points, and maybe even 5 or more. That’s because of the flaw in the Bureau of Labor Statistics’ hedonic adjustment, which totally misses the way the cost of technology declines over time. [By] the time the BLS puts something new in the CPI basket, it’s already cheap, so it misses the massive human-replacement price decline. Google Lens on a $35 phone, for example, can now translate and read aloud signs in 14 languages. Does the BLS capture the costs that technology saves compared with the services of human translators?

Although the Magic Formula doesn’t expressly address this issue, Mr. Lewis seems inclined to the shawdowstats view.

•Since 1970, the US government’s official CPI has been altered numerous times, and each time, the changes produced a sunnier picture than if the statistics hadn’t been changed. And yet, even by this heavily-scrubbed measure, “real wages in the US have stagnated since 1970.”

•. . . the “American lifestyle” that a single-earner family could afford in 1968, with limited debt and a 10% savings rate, seems strangely out of reach today even for a two-earner family.

Given that inflation may well be higher than is being officially reported, one has to wonder why the Federal Reserve and other central banks should be shooting for a 2% annual increase in the CPI. Although such a rate of inflation is low enough to seem bearable, it still favors the interests of borrowers over savers. Why not be impartial as between people in these categories by making overall price stability the goal?

It’s not clear that the inflation target is the true driver of central bank policy, at least in the US. Behind the smoke, Lewis suggests, some central bankers may be effectively working to get back to stable money policies versus gold, a basket of commodities, or some other currency (or currencies). Thus, for example:

Has America been secretly on the gold standard? We ask because as Janet Yellen nears the end of her term [2/3/18] as chairman of the Federal Reserve, the value of a one-dollar Federal Reserve Note is at 1,269th of an ounce of gold – essentially identical to the 1,262nd of an ounce of gold at which it was valued on the day [2/3/14] she acceded to the Fed chairmanship.

In any case, stable money has a far better track record than discretionary central bank policies designed to achieve economic goals like full employment or faster growth. Sooner or later, stable money based on the gold standard or some other procedure that involves a minimum of human judgment will win out for one simple reason. It works!

III. Combination effects – Economies can be tanked by blunders in running either the fiscal or monetary system. And once a policy blunder has begun in one system, it cannot be readily counteracted by policies in the other system – even though such a strategy might be seen as politically expedient.

In the numerous historical examples presented in the Magic Formula, trouble often surfaces in the fiscal system due to high spending. Personal excesses of some Roman emperors led to short-changed expenditures for the general population – foreign wars of Charles V were extremely costly - British attempts to recoup the costs of the French and Indian war from American colonists backfired – Britain in 1919 was not only saddled with wartime debt but also with welfare state spending introduced since 1900 - President Hoover’s first impulse at the outset of the Great Depression was to promise increased government spending – US federal spending peaked during the 1975 recession, the 1982 recession, the 1991 recession, the 2001 recession and, most dramatically, the 2009 recession.

Efforts to reduce deficits by raising taxes are typically counterproductive, as the real need is to cut spending and the tax increases are bitterly resented. Consider what happened in 16th-Century Spain, for example, when onerous new levies were imposed. “The outcome of this barrage of taxes in Castile was an explosion of tax avoidance, evasion and resistance.” Another well-known example is the American Revolution. And tax increases that Hoover backed to cut the deficit had a counterproductive effect, essentially ensuring that the Great Depression would have a long-lasting effect in this country.

When all else fails, governments can resort to currency devaluation – achieved by reducing the precious metal content of coins, printing more money, or in a central bank set-up adjusting target interest rates or monetary reserves. The typical result of devaluation, as has been shown repeatedly over the past 2,000 or so years, is declining currency values/rising prices for goods and services. And once devaluation begins, it may go further than expected. Consider what happened in the US during the 1970s, which in hindsight is viewed as a currency crisis versus an increase in the price of oil based on supply and demand.

Between 1970 and 1980, the value of the dollar, in terms of gold, fell from $35/oz. to a nadir of $850/oz., before stabilizing around $350/oz. in the 1980s and 1990s. [Meanwhile,] the price of oil soared from $3.07 a barrel to $39.50.

IV. Current situation – The government reacted to the financial crisis/recession in 2008-09 (aka the Great Recession) with a mix of fiscal and monetary stimulus, which may have been overdone but was probably inevitable under the circumstances. SAFE subsequently advocated efforts to change course.

Point one was to bring down or eliminate the budget deficit by cutting spending. Never mind a 10-year plan; cut spending now,

Point two was for the Federal Reserve to raise interest rates from near-zero levels and start selling the large increase in investments it had purchased for “quantitative easing” purposes, i.e., revert to pre-crisis monetary policies. Time to reset the central bank,

The incoming Trump administration and congressional Republicans supported a major tax cut in 2017 – thereby acting in apparent conformity with the “low taxes” principle espoused in the Magic Formula. Not all the details were to our satisfaction, notably the total absence of congressional efforts to cut wasteful spending, but SAFE supports what was done on taxes. Hopefully, the recent and proposed tariff increases – which could wipe out the tax cut that was delivered for Americans and then some – will wash out after serving their purpose as a bargaining tool rather than becoming permanent.

The Federal Reserve – now under the leadership of Lewis Powell – made a start on restoring pre-crisis monetary policy as SAFE had advocated. After 7 years (to Dec. 2015) at a level of 0.25%, the Fed’s target rate for federal funds was increased in 0.25% increments to the current level of 2.5% by December 2018. The bank has also made some modest reductions in its investment portfolio. Current Federal Reserve interest rates, Kimberly Amadeo,,

Critics (including the president and his economic advisers) have complained that the Fed moved too fast in raising its target rate, thereby endangering the economic recovery. But hasn’t the Fed been moving in the direction of restoring “stable money,” as advocated in the Magic Formula? While it can certainly be argued that the economy needs some stimulus to support faster growth, one might think an annual budget deficit of about $1 trillion (the outlook for the next year or two at least) would suffice for this purpose.

In principle, the Fed is in charge of setting monetary policy and not subject to presidential direction. In practice, the president’s views will be given considerable weight – especially with the apparent slowdown in economic growth since his “trade wars” began. The latest word is that the Fed is thinking about cutting (not raising) interest rates, perhaps next month, and the cut may be larger than a 0.25% increment. Fed will cut interest rates, James Langford, Washington Examiner,

"Markets are now pricing in a very high probability" that the Fed will cut rates at the monetary policy committee's next meeting, on July 31, with a good chance that it will be 50 basis points rather than 25, said Mark Haefele, chief investment officer at UBS Global Wealth Management.

Our vote would be to leave interest rates alone in July, based on a salient point from the Magic Formula – the oft-proven drawbacks of trying to use monetary policy as a tool to offset problems in other economic areas versus tackling those problems directly.

Thus, Lewis argues eloquently against using “austerity” measures (tax increases or tight money policies) to offset budget deficits versus trying to reduce the budget deficits directly. And using easy money policies to offset the adverse effects of trade wars on the economy doesn’t seem any more sensible, i.e., the goal should be negotiating new trade agreements without causing so much collateral damage. A split Fed decision, Wall Street Journal,

The best economic policy occurs when each important actor does well with the levers it controls. That means the Fed should focus on stable prices, while Congress and the executive keep taxes low and regulation limited. Mr. Trump can best help his own economic cause by ending the tariff uncertainty.


# I am not seeing any discussion of the need to change (and the expected change to a gold standard of) the Bretton Woods agreement, or the diminishing reliance on the petro dollar by an increasing number of countries. Nor am I seeing any statement to the effect that fiscal policy and the definition of value in the economic system trumps (no pun intended) the monetary system. Thus, the book and the review are incomplete. – Anonymous

Comment: As pointed out in the SAFE review/blog entry, Mr. Lewis expresses a strong preference for a return to a true gold standard (not Bretton Woods for reasons that he explains) or some alternative system that will deliver “stable money” without attempting to achieve other economic objectives, e.g., full employment. Furthermore, numerous historical examples are cited of economies that were tanked by blunders in running the fiscal system (typically starting with unwise spending or outright theft). Ensuing efforts to cure the problem by (1) tax increases, or (2) currency devaluation, typically compounded the original mistakes rather than fixing them.

#There are several loose ends in the “stable money” discussion: (1) The Fed has been using CPI ex food and fuel changes as the prime measure for its inflation target. Also, the CPI has been periodically redefined in a way that minimizes reported inflation. (2) One of the biggest items in a family’s budget is tax payments, so why don’t taxes (other than those included in market prices) show up in the CPI? (3) The US dollar is currently the global reserve currency, so its fluctuations versus other currencies would presumably be an indicator of stability or instability. (4) Although the price of gold in dollar terms has been comparatively stable of late, dollar vs. gold values have diverged sharply during other periods and may well do so in the future. In sum, I’m not convinced that the government knows how the monetary system works. – SAFE director

Comment: As Mr. Lewis sees it, the current monetary system cannot endure – and the only solution is to get back to the gold standard or some system that provides some assurance of delivering similar results.

#Keep up the good work. – SAFE director

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