Laffer in the WSJ
Jude Wanniski
January 8, 2001


Art Laffer's lead op-ed in today's WSJ, "Message to Bush: Cut Taxes Soon or Lose in 2004," makes plausible arguments on why tax rates should be reduced, but I'm afraid Art's story on the "Y2K inflation" is in error. He attributes the stock market advance of late 1999 and early 2000 to the Fed's huge additions to reserves as a precaution against bank runs if the computer bug caused a dramatic economic contraction. He asks us to believe the banks loaned out the reserves to people who wanted to get in on the NASDAQ gravy train and when Y2K passed without incident, the Fed withdrew all the surplus liquidity "in the blink of an eye," and thus pulled the rug out of the speculative excess on Wall Street.

As we pointed out at the time, the addition to "reserves" on the books of the banks came not through the monetization of debt by the Fed, but by truckloads of $100 Federal Reserve notes loaded on pallets that were stationed near the money centers. Piles of green paper all over the country awaiting a possible panic. The monetary base expanded because the Federal Reserve banks had to pay for the privilege of keeping the cash nearby, which meant it was recorded on their books. To the degree it was showing up in the money-supply statistics, it was because people across the land were holding much larger amounts of cash -- literally under their mattresses in many cases -- in order to make it through possible Y2K turbulence. This use of funds is of course non-inflationary, former Fed Gov. Wayne Angell has said repeatedly. The surplus "reserves" disappeared from the balance sheets of the banks "in the blink of an eye" because it turned out to be a non-event -- as the trucks took the unwanted cash back from the warehouses, and a bit more slowly from under the mattresses. Here is how David Gitlitz confronted the Y2K argument in a Metamarkets discussion today: "The monetary base is composed of currency and bank reserves. Vault cash is included in the definition of reserves. Late last year, as a contingency against potential depositor demand for currency during the Y2K rollover, the Fed boosted its provision of temporary reserves to the banking system in the form of vault cash. This accounted for nearly the entire acceleration of the base during this period. When the demand for depositor withdrawals didn't show up to anywhere near the extent that was feared, the banks shipped the cash back to the Fed, and the base fell back even more quickly than it had run up. It might be convenient to find surface correlations between this movement in the base and other observable phenomenon, but correlation isn't causation. Certainly, it's difficult to imagine that a major injection of excess liquidity by the Fed would coincide with the dollar strengthening against both foreign currencies and gold. Also, at this time there was very little acceleration in the growth rates of the monetary aggregates other than M3, over which the Fed has almost no direct control."

It is hard for me to realize why Art would make this argument. I sent him an e-mail a few weeks ago when I heard he was still making the argument, but got no response. It was Art who first taught me of the efficiency of the financial markets and the flaws in the quantity theory of money. Yet his Y2K argument asks us to believe ALL the markets were out of whack. A surplus of liquidity should first show up in the price of gold, but the gold price did not budge during the Y2K episode. That makes the gold market inefficient. A surplus of dollar liquidity means the dollar should weaken on the forex market. But the dollar remained stronger than dirt, which makes the forex market inefficient. And the yield curve remained inverted through this period when Art says the fears of inflation were rampant, driving up interest rates. It was Laffer who taught me to ignore cash-flow arguments in relation to price movements, because prices could easily change without cash transactions. It must be that I am more Lafferian than Laffer.