How to Thaw Credit, Now and Forever

Introduction –Working capital is the bloodstream of economic life. It is physical capital, the fast turning inventory of goods in process and finished goods that supplies materials to the worker, and feeds and clothes her or his family. Short term commercial loans and trade credit buy it, but the capital is “real” — a fact often forgotten in the paper and virtual worlds of high finance whence come the highest inner circles of government.

The bloodstream metaphor harks back to François Quesnay, an 18th century French physician turned economist. Quesnay drew on William Harvey’s (1578-1657) earlier discovery of how blood circulates. Adam Smith and other classical economists followed Quesnay, distinguishing “circulating capital” from “fixed capital,” the kind that is stuck in the ground or otherwise lasts for many years. Today we call the bloodstream metaphor “macroeconomics”, elaborated but not always improved from Quesnay’s insights.

Now the economic blood is drained down, and what’s left is slushy. We need to restore and thaw it, and get it circulating, right away as well as over time. To understand how, let’s see what drained it away in the first place.

My thesis here is neither purely Keynesian, nor monetarist, nor Austrian, nor Georgist, but combines elements of all those models in ways that are off “mainstream” thinking today. A great fault in the first three models is ignoring the “wealth effect” role of land as “fictitious capital”, and treating all taxes as alike. The fourth (Georgist) model lacks a good concept of how capital circulates. Some readers may find it puzzling and alienating to proceed without one of the old familiar models. Considering where mainstream thinking has led us, and how dismal are its forecasts now, and how it lacks any positive guidance for recovery, it is timely to seek a new mainstream.

2. Public debt as vampire

Each Federal deficit draws more blood from the private sector. Cumulative deficits add up to the national debt. Washingtonians used to joke about a hick Congressman whom the voters returned for several terms because he never voted against an appropriation or for a tax bill; but now the Republicans, once the reliable foes of public debt, have doffed their green eye-shades and become its champions. The debt was $900 billions when Reagan and Bush Sr. took office in 1981. In 1984 Mondale/Ferraro campaigned to stop the bleeding, but voters chose the lure of lower taxes and higher spending. When Bush père left office in 1993 the debt was $4,000 billions, a number so high we started counting it in trillions.

From 1993-2001 the pendulum swung back as President Clinton came to terms with the newly-thrifty Republican Congress. Equally important, he did not invade any other nations. Some military bases like The Presidio and Marin Headlands were actually closed, rare as that is; others, like March A.F. Base, were mothballed. Under this regimen the nation recovered from several shocks that might have triggered the collapse of a more anemic economy. Some of these were the Mexican bailout of 1994, the southeast Asia crises of 1997-98, the flame-out of Long Term Capital Management in 1997-98, the dot.com collapse of 2001, and the stock market fall from 2000-2002. Now, however, President Bush fils and his supportive Congresses have run the debt up to $11 trillion, $12 trillion, $13 trillion or more, depending on who’s counting. Whichever way recorders spin the story, the debt is a big fraction of the nation’s capital – our economic blood. This has made us vulnerable to the housing crash and cardiac arrest of today.

How did Reagan and Bush persuade themselves to invert traditional Republican doctrine? There were two main gurus: Art Laffer, Jr., and Robert Barro.

Laffer drew his famous curve on Dick Cheney’s cocktail napkin in 1974 and changed the course of history. Said Laffer, taxes suppress incentives so much that Washington can actually collect more money by lowering tax rates. He stressed how taxes “suppress” incentives to work and to invest. Others also stress how taxes twist incentives so people allocate resources less efficiently.

Anyone who has read Henry George will relate to how taxes suppress and twist incentives. Laffer, indeed, quoted him often and enthusiastically. Tragically, though, he only got half or less of George’s idea. Laffer never specified WHAT or WHICH taxes suppress and twist incentives. George, of course, would maintain revenues by raising the neutral and even pro-incentive taxes on land values and rents, to compensate for down-taxing other bases. He noted that down-taxing other tax bases would enhance land rents and values as a tax base.

By 1979 Laffer had political distractions in mind, like rising with Ronald Reagan. The voters loved their message of lower tax rates cum higher public spending, and Reagan used it to help win his election. Laffer never rose to the heights of a Cardinal Richelieu, but he served on Reagan’s Economic Policy Advisory Board for both of his two terms, as well as the Chief Economist at the Office of Management and Budget under Treasury Secretary George Schultz. Reagan and later Bush père bought into Laffer’s plan to lower tax rates, even as Reagan’s other economists advised against it. Laffer also got OMB to adopt “dynamic revenue forecasting” based on assuming that lowering tax rates would raise the tax base.

Within a few years it was clear that Laffer’s tax cuts actually lowered revenues, and he lost favor. Yet today his ideas linger on in the highest circles of government. Professor Jeffrey Franken of Harvard has published a series of Laffer-like quotes from Bush fils and various sympathetic Congressmen (2008, Tax-cut Snake Oil, Economic Policy Institute).

The other new guru was Professor Robert Barro, then of Rochester, now of Harvard. The same Dick Cheney, a believer, tersely summed up Barro’s message: “Deficits don’t matter”. Barro claims to trace his idea back to Ricardo, and even calls it “The Ricardian Equivalence Theorem”. It is loosely related to the assessors’ theory of property tax capitalization - we leave that for another day. Barro’s point is that deficits today mean higher taxes tomorrow. Present taxpayers and savers fully realize that, says Barro, so they will save more today to prepare for that burden of tomorrow. This higher private saving offsets government’s dissaving. As of now Barro is still repeating this chorus with each verse: “… it matters little whether you pay for government spending with taxes today or taxes tomorrow, which is basically what a fiscal deficit is” (Interview with FRB of Minneapolis, Nov. 12 2005, in The Region). In other words, “Deficits Still Don’t Matter” to Barro.

It was not just Barro. Iconic Milton Friedman, the very avatar of anti-Keynesianism, chimed in with “Why twin deficits are a blessing” (WSJ Dec 14 1988). (The other deficit was our national import balance.) Friedman had risen to fame by refuting Keynes and giving us his “monetarism” instead. Once in favor, however, with Keynes reduced to a memory, Friedman turned around and endorsed a new rationale for deficit finance, Barro’s “Ricardian Equivalence Theorem”.

This Barro-Friedman rationale has a seductive element of truth, but more error. The primary effect of deficit finance is that government bonds, to their owners, are an asset, a “store of value”, a substitute for real capital. George and others labeled bonds as “fictitious capital” – they are nothing but a lien on future taxpayers, yet they swell their owners’ portfolios just as though they were real social capital. Thus they satisfy people’s needs for retirement funds, and other comforts and joys of holding wealth, without the people’s having created real capital by their saving. For most people (not all) the marginal satisfaction from holding additional wealth diminishes as they hold more. Economists call this “the wealth effect”, even when the wealth is fictitious. (For those whose marginal satisfaction from holding wealth does not diminish see Gaffney, 4- 04, Auri Sacra Fames, in Groundswell. The fable of King Midas is also in point.)

By substituting for real capital, bonds lower people’s marginal incentive to save and invest more. Barro recognized this wealth effect. His point was that it is offset by the negative wealth effect of the prospect of higher future taxes, so “Deficits don’t matter”.

It is true that some bonds do represent real social capital, as when public bodies spend the money wisely and honestly on useful objects and services of general value, like scientific research, replacing worn-out roads and bridges, air traffic control, education, and so on. Ideally, all bonds would. The apparent dissaving would be offset by investing in public and human capital, raising incomes and land values to fortify future tax bases to retire the bonds.

History cries out, however, that nations in thrall to imperial overreach and its parasitic lobbies fritter too much capital away on sterile warfare (Kevin Phillips, 2006, American Theocracy). Urban history, studied with any insight, shows cities, counties, states, and nations, dominated by land speculators, doing the same on subsidizing urban sprawl. Alaska’s “bridge to nowhere”, even though aborted by the publicity and embarrassment surrounding its patent absurdity, dramatizes the matter memorably. (Alaska finally got the money anyway, for Heaven knows what.)

Our huge and ongoing foreign trade deficit shows that the investment crowded out of domestic industry must exceed private sector gains from public spending. That is why we have to buy so much from abroad, and can sell so little there. How could it be otherwise when so much public spending goes to maintain hundreds of military bases around the world, bribes to manipulate foreign rulers, long wars without apparent net benefit to the U.S., and the whole military-industrial complex?

An analogy to slavery may make this clearer. It is a truism of economic history that slaves in the Old South satisfied their owners’ need for wealth, substituted for real capital in their portfolios, and led to a culture of extravagance. Formation of real capital suffered. So, of course, did the slaves, who also substituted directly for farm capital. Underequipped Confederate soldiers paid the price on the battlefields.

As a secondary effect, the prospect of future taxes is a liability to bondholders and other future taxpayers – the “negative wealth effect”, as Barro says. It is unlikely that this distant future possibility shows up on the liability side with the same weight as the bonds on the asset side, as Barro’s critics have pointed out. Most of these critics, right as they are, have failed to add that our tax structures at every level have been growing less progressive, or more regressive, so future taxpayers are more and more likely to be the working poor, rather than the saving classes. Add to that that our system is fast making it worse by racing toward distributing wealth and income less equally

The net marginal satisfaction from holding wealth actually diminishes more and faster when the wealth consists of real capital. This is because owners of real capital, especially working capital, must manage and maintain it, and constantly replace it as it turns over. This is hard work, and risky, too. Bonds, in contrast, keep in a vault with no such cares. Only the most durable forms of capital, gold, land, and some common stocks can compete with government bonds in this respect (Gaffney, 4-04, op cit). So big savers, as their wealth accumulates, more and more turn away from supplying working capital like short term commercial loans and trade credit.

Working capital, the coursing bloodstream of our private economy, needs a heart – the owner-entrepreneur - to pump it through the system and recirculate it constantly, often several times a month. But the stoutest heart cannot pump blood that is not there, as we are finding today. It is not just loanable funds that are short, not just abstract “credit”, as popular and media perceptions have it; it is the real capital that loans and credit represent. That is why we have to import so much of the real capital.

Government bonds “crowding out” private wealth from portfolios is part of how government borrowing takes capital away from the private sector. The other part of crowding-out is dynamic. When The Treasury sells new public bonds they crowd out new private bonds and corporate IPO’s and new investing in unincorporated businesses, most of them small.

Professor Martin Feldstein sees the wealth effect mainly in social security, which he blames for the shortfall of private saving. The comfort and security of knowing your rich Uncle Sam will cover your later years obviates your saving in other ways. Buying into social security, even though it is involuntary, is like buying a government bond. You invest now and recoup later. Feldstein does not qualify this, as Barro might, by claiming that the prospect of higher future taxes to pay the retirees will stimulate more saving today.

Feldstein’s emphasis on the wealth effect makes sense, up to a point, but his case has elements of class bias that weaken it. If he is going to make this case against social security pensioners he should make it more strongly against bondholders. For one thing their claims on future revenues, rising over $10 trillion plus huge annual interest payments, outweigh the annuitants’ claims under social security.

For another thing, social security annuitants include many people too poor to save much in any event, so their prospect of a secure old age does not abort much saving they would do in the absence of social security; it simply saves them from indigence, eviction, the poorhouse, dependence on family welfare or charity, and, more than likely, early death. For a third point, there is an invidious subjective value in private wealth, lacking in social security. Everyone has social security, so it does not make a man or woman feel wealthier than his or her reference groups.

Critics fault the social security “trust fund” because it is not really saved, but spent for current Federal operations and wastes. Worse, it earns only about 2% a year, less than inflation, making it basically a forced loan to the U.S. Treasury and, indirectly, to other, richer taxpayers. More often than not these critics write with a political edge, but our concern here is with the economics of it. Objectively one should add that it is also spent to lower taxes on others with more ability to pay. In the short run it is just a tax, our most regressive one by far.

This tax does not crowd much capital out of the private sector; the poor workers who pay it are being forced to save what they otherwise would consume. It is not by their choice that Congress uses their money to lower taxes on corporations, on the sensational peculations of CEO’s, on those in what used to be tax brackets as high as 94%, on “capital” gains, on estates, and on property income of most kinds. It is those beneficiaries who would reasonably be expected to pay more future taxes to repay the pensioners, but there is little reason to think they will, without a radical turnabout in the evolution of tax policy. On the contrary, the pensions themselves have now been made taxable, and Congress has stiffened bankruptcy laws so a tax delinquent without property may become an indentured servant of the state for life.

3. There is a Greater Dracula, land value, sucking blood from our economy. Land value is invisible to most economists. Those cited above, however deep their insights about public debt, rarely mention it; their neo-classical training blinds them to it. Feldstein has written of “The Henry George Theorem”, but in another context, in a mental compartment sealed off from the present issues.

We noted earlier that U.S. bonds serve as “fictitious capital” to their owners, a store of private value that is not real social capital. So do land values, only moreso. They satisfy the need to hold assets without there having been any corresponding net social saving by owners collectively, present or past. Individuals may save to buy land, but the seller dissaves in the same sale. Most home buyers, in fact, finance their purchase from selling a previous home. Mere ownership turnover of a fixed stock does not constitute net social saving.

Not only do land values substitute for real saving, they promote dissaving. Notoriously, we have just been through several years of homeowners’ heeding the siren songs of bankers to “unlock the equity in your house (and its land)” to pay for cruises, cosmetic surgery, golfing, yachts, vacation homes, fast cars, stables, and any other extravagance that lust and envy and boredom and impulse can devise. Rising land values seem to the owners like current income that they can spend on current consumption, so long as banks are ready to lend on them. That is the dynamic side of it. Then, after the values have risen, they stand in for wealth to some owner or lender, muting via the wealth effect their urge to save.

In the case of U.S. bonds there is a reverse or compensating Barro Effect. In spite of Barro’s overstating it, still there is something to it. It is a “negative wealth effect” from the prospect of higher future taxes to pay off the bonds, even though it is, as shown above, only an echo of the “wealth effect” of the bonds to their owners. There is no corresponding Barro Effect with rising land values, they rise up spontaneously, on their own. They are a free gift from human fecundity and progress, economic and social. They result from our having traveled a few more years through time, into the infinite future. Infinity remains infinite. It has simply grown more highly rentable, in the rosy visions of optimists, the ones who dominate the market. The land in a portfolio of assets is not, per se, a debt that someone must retire.

It is true that prospective buyers are now poorer, in that they must pay more for land. This might stimulate them to save more. However they, too, share the vision of higher future rents, so they are paying more simply because they think they are getting more. Sometimes they actually are. If the price to rent ratio rises it is because of the promise of higher future rents or resale values, whether or not the promise comes true.

What about common stock? I omit it here for four reasons. One, a good deal of its value represents indirect ownership of real estate. Two, in our times its total value has dropped well below that of dwellings. Three, the media and public consciousness greatly overstate its role in the economic scheme. News reporters parrot phrases like “a fall of stock prices has wiped out a trillion dollars of wealth”. The wealth is still there; all that’s changed is expectations of future earnings, or taxes, or subsidies, or bail-outs, or even more trivial and superficial matters. Four, space and time limit us here and now: we must neglect something. What’s uppermost now is the housing collapse.