MEMO To: Alan Greenspan, Chairman, Federal Reserve Board
From: Jude Wanniski & David Goldman
Your remarks in Tokyo yesterday indicated that a dramatic rise in U.S. economic growth is not feasible or desirable. The statement attributed to you is that the current slowdown in the U.S., Japan and Europe is unusual in the post_war era because it reflects the needs of borrowers to reduce the "overload" of debt after prices of collateral have declined sharply in recent years -- and that this adjustment from the debt overload has "taken much longer than many of us expected." You reportedly said the diversion of cash from goods and services into reducing debt has reduced the growth of the U.S. economy from what it otherwise would have been and that you cannot predict with certainty how much longer this will take.
We understand your reasoning but emphatically disagree that rising economic growth is neither possible nor desirable. The economic phenomenon you describe was of course responsible for the deep recession of 1981-82. The Federal Reserve inflated madly in 1979-80, as evidenced by the rise in the gold price to $850 at one point in early 1980. When the Fed subsequently tightened, the deflation crippled dollar debtors in the United States and around the world. The gold price sank back toward $300 and commodity prices followed, as debtors ran off inventories seeking scarce liquidity to meet their debt obligations. Bankruptcies were rampant. You may recall many supply-siders at the time complained that the deflation was too steep -- we began pleading for ease when gold hit $425 in early September of 1981. We also screamed against the delay and phasing in of the Reagan tax cuts that were engineered by David Stockman in an attempt to narrow the budget deficit. If the tax cuts had taken place in 1981 instead of being phased in during 1982-84, the recession would have been avoided, we thought, because this would have increased the value of capital assets -- equity -- to offset the decline in the value of debt. Bob Bartley discusses this in detail in his book Seven Fat Years .
Almost all of the adjustment to that inflationary binge is behind us, in good part because of your management of credit policy these last five years. This is why we applaud your keeping gold as near as possible to $350, to avoid another bout of inflation/deflation. In and of itself, of course, there is nothing wrong with debt, even lots of debt. For every dollar borrowed there must be a dollar saved. For every dollar debt there must be a credit. As the Federal Reserve is in control of the nation's credit policy, and you are the boss, it is not logical to suggest that credit growth can be optimal while debt growth is suboptimal.
We know you agree that the growth of credit is optimal when it is facilitating the development of human and physical capital, as this process not only assures low inflation, but also increases the present value of future income streams -- the value of equity. We will grant you that you have little room to improve credit growth through monetary policy, except perhaps to increase the predictability of $350 gold. Fiscal policy remains, though, as a means of increasing the value of equity. Fiscal policy, we think, is suboptimal in that it continues to bias the economy to debt as opposed to equity. You surely agree we could get a desirable, rapid, non-inflationary growth rate with an optimal tax rate on capital. An end to the double taxation of dividends and a lower, indexed capital gains tax would do just that. The stock market would rise and so would the volume of debt, and you would not be unhappy at all, observing gold steady at $350 to guarantee credit growth remains optimal.
As it is, we do not find the evidence that debt is suboptimal even now. As the graph shows clearly, the best measure of the debt burden on the private sector -- the ratio of debt to market value of U.S. non-financial corporations -- remained stable during the 1960s, exploded after the collapse of Bretton Woods in 1971, and fell during the Reagan years. It has remained stable since then, yet we have slumped from a 4-6% annual growth rate during the mid-1980s to lingering stagnation. How can debt explain slower growth? Indeed, there is very good reason to believe that the change in this ratio over the entire period reflected efforts by firms to adjust their capital structure to changing inflation expectations, loading up debt when they expected more inflation and vice versa .
More fundamentally, we believe that the willingness of households and corporations to spend or invest depends neither on their debt burden, nor on their savings, but on their expectations of future growth. America is floating on a sea of unused collateral, expressed in private assets. Private net worth as of 1990 totalled $17.1 trillion, about triple the Gross National Product. Homeowner equity alone makes up $4.6 trillion of this sum. Very small changes in growth expectations bring about enormous changes in asset valuations relative to current income. A 2% rise in the market valuation of private assets, for example, would increase private assets by $350 billion -- as much as the budget deficit! The annual change in the gross savings by the private sector as reported in the national income accounts has ranged between a mere $50 and $100 billion during the past decade. Meanwhile, private assets increased by an average of 9% p.a. between 1980 and 1990. Individual's decisions as to how to employ their assets set in motion changes an order of magnitude greater than changes in the savings rate.
Where this affects growth, exactly the reverse of your reported statement is true. The problem is that Americans do not want to borrow, or lenders to lend, against the trillions of dollars of available first-class collateral in order to take risks. As we have noted, business starts have fallen for six years running, a decline unprecedented in the postwar era. Almost all employment growth during the past decade stemmed from small business. Small businessmen typically obtain start-up capital by pledging the equity in their homes. Why have they not chosen to do so since 1986? The answer, we insist, is that the fiscal system has been stacked against risk-taking since the increase in the unindexed capital gains tax.
Individuals have enormous discretion about the composition of their portfolios. The data show that Americans have turned risk-averse during the past six years, preferring to hold tangible assets and debt rather than high-risk equity in start-up enterprises. A change in the odds favoring risk-taking, starting with a reform of the industrial world's most oppressive capital gains tax, surely would motivate individuals to shift their portfolios in favor of risk assets. This shift would dwarf the size of any imaginable change in the savings rate. From this standpoint, the United States could easily return to the high growth rates of the mid-1980s. The increase in market value of securities and tangible assets resulting from a tolerable capital gains tax, meanwhile, would improve the balance sheet of the private sector.
At bottom, we do not think you need to rationalize the economy's slow growth in order to defend your conduct of monetary policy. You've done a superb job on that account. The achievement of more rapid growth lies in the realm of fiscal policy, over which you have no control, but in which you could have great influence.