Greenspan Flaw
Jude Wanniski
September 8, 2004


 I watched the 2-½ hours of Fed Chairman Alan Greenspan’s testimony before the House Budget Committee this morning, as always looking for clues. As has been widely reported, he didn’t say anything “new,” which is why neither the stock market nor the bond market budged during his presentation. Bloomberg’s headline from his prepared remarks was: “Greenspan Says Expansion ‘Regained Some Traction,’ Oil Not Boosting Prices.” With no questions about monetary policy, he was almost flawless in batting back questions about the $422 billion deficit in this fiscal year. If it were not for the one “flaw,” I would probably not ever bother you with this brief, but it is important.

In response to several questions, Greenspan repeated again and again that the Bush tax cuts would not lose as much revenue as the tax cut implied, as there would be some feedback effects. It would not be “small,” he told Rep. Henry Brown [R SC], for example, but it would not be 70%. He actually said “no economist” believed it would be 100%. “You should not borrow the tax cut,” he said, meaning it should be paid for by spending cuts. “You will increase the deficit, but not as much as the tax cut.” A number of Democrats on the committee leaped on this “admission,” one noting that Greenspan did not buy “supply-side.” On the other hand, Greenspan admirably defended the long-term effects of the Bush tax cuts, telling Rep. John Lewis [R GA] that the implied $2.5 trillion “revenue” loss over 10 years was not being “stolen” from Social Security and Medicare, but was actually designed to “expand the tax base.”

Where’s the flaw? Greenspan clearly does not have it fixed in his mind the theory behind the Laffer Curve as expressed by Robert Mundell back in 1974. Here is how he put it in my essay of that year in The Public Interest, "The Mundell-Laffer Hypothesis":

Tax rates have been put up inadvertently by the impact of inflation on the progressivity of the tax structure. If the tax rate were below the rate that maximizes revenues, tax cuts would reduce tax revenues at full employment. But a multiplier effect operates if the economy is at less than full employment, and the tax cut then raises output and the tax base, besides making the economy more efficient. Even if a bigger deficit emerges, sufficient tax revenues will be recovered to pay the interest on the government bonds issued to finance the deficit. Thus, future taxes would not have to be raised and there would be no subtraction from future output. Tax cuts, therefore, actually can provide a means for servicing the public debt.

In all my years of Greenspan watching, I’d never before realized that he did not understand the obvious point Mundell made, that as long as the economy grows fast enough to cover the interest on the bonds issued to finance the deficit initially caused by the tax cut, the tax cut will actually service the debt. Greenspan sees the long-term investment paying off, but not the short term. This helps explain why he can’t explain the serious productivity gains he marveled at again this morning. The tax cuts on capital last year may have already paid for themselves even in the short term, which is what Greenspan himself could have noted when he said “no economist” believed the feedback in the short term would be 100%. The lower federal tax rates on capital gains certainly have paid for themselves, throwing off revenue gains at all levels of government. At the same time, the Mundell Phenomenon helps explain why interest rates are so low, not because the Fed has kept the federal funds rate low, but because capital has become so abundant with the lower tax rates on capital. 

Someone should explain this to Senator Kerry, who promises to reverse the process by increasing tax rates on those most efficient in forming capital. But because Greenspan did not make it clear, the Democrats on the committee came away thinking the Chairman was basically on Kerry’s side. It should have been clearer when they asked Greenspan if it was not true that more jobs were lost in the last four years than under any other President since Herbert Hoover. Yes, yes, said Greenspan, but productivity has also increased faster in the last four years than under any other President since Hoover. And the one is the mirror image of the other, he said. That’s because the increased productivity has allowed businesses that would otherwise have failed to remain profitable by shedding workers not needed to produce the same level of goods and services. In the short run those workers being shed have difficulties, but this is the way the nation as a whole increases its standard of living, so he said. 

Maybe there is some way to fix the one flaw in his otherwise flawless presentation. If he could make that case to Congress as a whole, Democrats might be just as prepared to look for those special cases where the Laffer Curve works as Republicans have been, in cutting taxes where the situation Mundell described in 1975 exists or not.

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