FOOL ON THE HILL: An Investment Opinion
George W. Bush vs. Alan Greenspan

The Republican economic plan seems to be centered around large tax cuts, which could turn out to be bad for the economy. A tax cut would probably force the Federal Reserve to raise interest rates to avoid inflation, which would slow down the rate at which the national debt is repaid. This is a bad thing, and also unnecessary while the economy's going so well.

By Rob Landley (TMF Oak)
August 21, 2000

Austinites have mixed feelings about our state governor, who local columnist Molly Ivins has nicknamed "the shrub" (i.e., little Bush). If he gets elected, he becomes president. On the other hand, it would get him out of Austin. Personally, I've been toying with the idea of spending a few years in England anyway. Let me explain why I think Bush's plan is going to damage the U.S. economy.

Last year I wrote two articles describing my strange take on economic theory. The first defends the assertion that there's no such thing as money. The second covers what a man named Alan Greenspan does for a living. Between the two of them, they explain why I think the various tax cuts perpetually proposed by random Republicans would probably be a bad thing to actually implement.

When Greenspan plays around with interest rates he's actually controlling the money supply. When people borrow money and spend it, the people they borrowed the money from still have it, and the people they gave the money to also have it. So there's now twice as much money in the system, even if some of it's only temporary (until the debt is repaid). And what is there is kept in circulation.

Money is an economic lubricant. It doesn't create goods and services and it doesn't consume goods and services, it allows people to exchange goods and services with money as a way of keeping score. If there's not enough money in the system the goods and services stop flowing, and if there's too much the flow exhausts the supplies and you get inflation.

The Federal Reserve (of which Alan Greenspan is still chairman) controls interest rates. When goods and services aren't flowing at capacity, interest rates go down so people borrow money and lubricate the economy. When supplies are low and inflation looks like a problem, interest rates go up and money drains out of the economy as existing debts are paid off faster than new borrowing replaces them. This slows down the rate of consumption until the supply of raw materials can catch back up.

A tax cut injects more money into a delicately balanced system, tipping the balance towards inflation. The information revolution has generated great wealth without stimulating as much inflation as expected primarily because information based business on the Internet don't consume raw materials like lumber or steel resulting in supply shortages. But the raw material they do consume -- the labor of technically proficient individuals -- is in EXTREMELY short supply. Here in high-tech Austin, unemployment is 1.9%, even though 5% of the population is traditionally unemployable.

This kind of turnover is hard on human resources departments, which have to hire warm bodies to fill empty positions and wind up poaching employees away from other companies just to break even. On the bright side, the technology "have nots" are now a valuable commodity. With labor this tight anybody trainable and willing to learn is a good find. Another avenue to ease the pressure is looting other countries for employees via H1-B visas. And substituting stock options for cash salary is an extremely popular way of at least disguising inflation. But however you look at it, the labor supply is engaged to the hilt. More demand will drive salaries up, but won't squeeze blood from a stone in terms of productivity. Companies are already trying to do that in the name of profitability.

So what a tax cut ends up doing is forcing the federal reserve to raise interest rates to keep the economy from overheating. Full employment is a good thing, but an employee shortage is inflationary. Salaries going through the roof sound like fun until you try to buy a house and find that prices have more than doubled in the past three years. And if a business has to pay higher salaries to get workers, its costs of production have gone up. Eventually, the higher price level distributes itself through the economy. (Hands up everybody who thinks gas prices are ever going back down.)

Meanwhile, we'd be throwing away an historic opportunity to pay down the national debt. A certain amount of debt is good for the economy, it motivates the debtors to work to pay off their debts and provides profits for the lenders in the meantime. But private debt is better than federal debt. All an indebted government is motivated to do is levy taxes; it can't increase its profits by working harder. Low interest rates encourage private spending (increasing the debt load of individuals and corporations, which isn't necessarily bad if it's a mortgage or a small business loan to an entrepreneur). At the same time, the low interest rates reduce the interest payments on the multi-trillion dollar national debt, bringing the federal budget into the land of surpluses that make paying the debt down possible.

If a tax cut forces interest rates to go up, not only would the money devoted to the tax cut not be applied to paying down the debt while such a thing is possible, but the increased interest payments on the national debt could easily drive the federal budget back into the red even if nothing else changes. This has a ton of bad side effects on future taxes, future effectiveness of the federal government, the strength of the U.S. dollar relative to foreign currencies, etc.

This is why I think a major tax cut right now really is not a bright idea.

- Oak

Related Links:

  • No Such Thing as Money, Rule Maker Portfolio, 7/19/99
  • Oversimplified Economics, Rule Maker Portfolio, 7/23/99