Jude Wanniski
May 29, 1998


Supply-Side University Q&A

Memo To: Supply-Side University students
From: Jude Wanniski
Re: Q&A

We're not going to have a formal SSU summer-school session, but will devote the Fridays and weekends to economic topics, guest lectures from interesting people alive and dead, and the Q&As you send.

Q. From Bill Kunberger: I just read your memo to the editors of the Economist. Maybe I'm missing something, but I don't see how you can dismiss their evaluation of the bull market out of hand. They may well be wrong, but I don't see that it's obvious. Let's go back to the crash of'87. The stock market lost about 20% of its perceived value in a day. So either the day before the crash the marketplace greatly overvalued the stocks on the NYSE, or the day after it greatly undervalued them. Their underlying value cannot have changed so abruptly in a single day. If the marketplace was wrong on one of those days, why can't it be wrong now?

A. Crashes occur when expectations about the future change. When a political leader who is in a position of changing global expectations by a word or the stroke of a pen makes the wrong choice, the value of financial assets can fall dramatically in minutes and hours. The underlying value of an asset, as you put it, is its ability to produce income as far as the eye can see. If the market perceives the future differently, the asset's underlying value changes immediately. If we were to hear that Mark McGwire of the St. Louis Cardinals broke his thumb, the betting odds that he would hit 60 homers this year would change instantly. There is no bubble, though. The Economist idea of a bubble is that people are like sheep or lemmings, and when they see each other buying stocks and bonds, they pile on with their own cash. In this way, there is no good reason why assets rise in value, just the herd instinct, the madness of a mob. The Economist essentially rejects the idea that the financial market is efficient, which is why it is essentially a socialist periodical. The idea of driving down the value of an asset on purpose, like letting air out of a tire, is in my mind the true madness. The Economist has been on the wrong side of almost all economic issues for the past 30 years. Its editors were all trained to believe in the imperfections of markets, which requires very smart economists to come in and tell political leaders how to correct those imperfections.

The Crash of'87 occurred when the market was informed by the Treasury and the Fed's new chairman, Alan Greenspan, that the Louvre Accord of 2/87 was dead. That accord was aimed at keeping the dollar stable against the yen and DM. In the few days before the Crash, the market began to crumble as it began to appear that Treasury Secretary Jim Baker would retreat from the Louvre Accord. Then Fortune magazine came out with a Greenspan interview, in which he said he believed the dollar would have to be devalued by 2% a year for the indefinite future. Over the weekend, Baker and his aides confirmed that they believed it was the Bundesbank's responsibility to stabilize the dollar/DM rate, not ours. This news told the markets that the United States was taking no responsibility for ending dollar inflation, thereby increasing the risks of holding all dollar assets, especially equities ~ inasmuch as there was no indexing protection for capital gains.

Q. From Ted Kopczynski: It is often said -- in the pages of the WSJ -- that our trade deficits (current account shortfalls, I think) are equal to "foreign investments," which are supposed to make up for our low "savings." Why is this true? What kind of foreign investments? And why should THAT fact cause trade deficits?

A. Most of the commentary on this subject is the result of the static nature of the Keynesian demand model. Because it is true that Production = Consumption + Savings, the Keynesians argue that we have to consume less in order to save more. Note that whatever the combination of consumption and savings, production remains constant. In the supply model, we forget about the "savings rate" out of production and concentrate on increasing Production. If there is more production, there will be more consumption and more savings, right? Even if the added increment of production is entirely consumed, with none saved, the economy is better off than with lower production. Note that if savings remains the same and production is higher, the "savings rate" is lower as a percentage of the whole. This is why authentic supply-siders reject the idea that the savings rate, per se, is of any importance.

Having gotten this point out of the wray, let's discuss the issue of trade deficits and foreign investments. It is quite simple. If we buy a million apples from Japan for $1 million cash and the Japanese use $900,000 to buy 900,000 oranges, the Japanese have $ 100,000 left over. If they do not wish to buy anything else for immediate consumption, they can buy $ 100,000 worth of stocks or bonds from our financial markets. Or, they can send a man over with the money to buy a piece of property here. Maybe a small restaurant. If we bought a billion apples from Japan and they had $ 100 million left over after buying oranges, they would have enough to buy a factory in Ohio. In any case they have to buy SOMETHING from us with the dollars left over. Either present goods or "future goods," which is what a financial asset represents, some sort of claim on a future good or service.

In other words, in this example we are buying and consuming all the apples and the Japanese are only consuming 90% of the cash they get, in oranges, using the rest to invest for future consumption. There is never any reason to worry that the United States is running a trade deficit or a trade surplus. Either one could represent a healthy economy or an unhealthy economy, depending upon other pertinent facts. If we were suddenly to impose a great increase in our income tax, or double the capital gains tax, or devalue the dollar by some significant amount, the stock market would fall sharply, signifying bad times ahead. We would then expect the trade deficit to move toward surplus!!! That is, our citizens could not afford to buy a million apples from Japan, only 900,000. And China, finding oranges for sale here at bargain basement prices, would use all the cash from their apples to buy oranges. Maybe they would even cash in some of their stocks to buy more bargains here. Our production would rise, even though the statistics would show that our "savings rate" increased.

Q. From Michael Williams: The Wall Street Journal says the Russian economy is stumbling because its tax rates are too high. What are the rates? What would you recommend the Russians do?

A. Russia's personal income tax, "reformed" as of January 5, 1998 when they knocked three zeros off the nominal value of the ruble, can now be calculated in dollars at the rate of 6.2 rubles per dollar. This is roughly what I get with my little pocket calculator.

Income up to $3225 @12%

Income from $3225 to $6450 @ $387 plus 15% over $3225
Income from $6450 to $9677 @ $871 plus 20% over $6450
Income from $9677 to $ 12900 @ $ 1516 plus 25% over $9677
Income from $ 12900 to $ 16130 @ $2322 plus 30% over $ 12900
Income from $16300 @ $3290 plus 35% over $13000
Also 10% VAT for food and children's goods
20% VAT for everything else

These are better rates than existed previously, but still too high, particularly since there is so little accumulated wealth in the hands of the people. The tax system is not too much different than Mexico's, although Mexico does not tax the first dollar of income as the Russians are trying to do. Mexican citizens have a significant amount of wealth that can be invested or collateralized in order to invest in the rest of the economy. Russia has to permit individuals to become wealthy through investment of after-tax income, which is hard to do when you tax income so high. The IMF is trying to get Russia to spend less, to conform to its idea of what the annual deficit should be. Russia's deficit is only 5% of GDP and its national debt is only 16% of GDP - as a result of the government having inflated away its previous debt, held by its ordinary people in the form of ruble deposits which became worthless. When the IMF began "helping" Russia, the black market rate was four rubles to the dollar. The rate went to 6200 to the dollar, prior to the cosmetic change by taking off the last three zeroes.

By the way, Mexico's income-tax rates are much too high. I would suggest for both Mexico and Russia a simple three rate system of 10% at income over $5000, 15% over $10,000, and 20% on income over $20,000. There should be a $1000 per person allowance and no capital gains tax. Mexico and Russia are comparable in their level of human capital, as both have high rates of literacy.

* * *