Washington, D.C., is a funny place. It’s probably the only place on Earth where a majority of people turn to the editorial page of the newspaper before they read the sports page, and they think the rest of the world does, too. But Monday, I bet even the politicians read the sports page first to see who won the Super Bowl.
That said, this past Super Bowl Sunday the news that Federal Reserve Board Chairman Alan Greenspan made when he came out in support of an across-the-board tax rate reduction and a cut in the capital gains tax rate should command the whole nation’s attention. The Baltimore Ravens are now the NFL champions, but in Washington, we are in the first quarter of another Super Bowl — a political-economic contest between the Taxers and the Tax-Cutters. Mr. Greenspan’s remarks before Congress make it clear that the outcome of this contest during the next couple of months will determine whether we kick off a new season of vibrant economic expansion or settle down into a slow-grinding overtime in the current deflationary contraction.
Contrary to popular opinion, the determining factor will not be whether President George W. Bush’s tax-rate reduction is enacted into law or whether the Fed cuts interest rates by even as much as a full percentage point during the coming weeks and months. Both tax rate reductions and a change in monetary policy are certainly essential if we hope to put the economy back on a noninflationary, high-growth path long after this economic slowdown is over. But neither alone is sufficient, and contrary to another popular’ misconception, tighter money will not be required to temper any mythical inflationary impulses set up by tax rate reductions.
Just the opposite will be true. Across-the-board tax rate reductions and a cut in the capital-gains tax rate, especially if capital gains are indexed for inflation, will increase the after-tax return to productive activities and require the Fed to increase the supply of money to markets hungry for more liquidity.
It is vital for policy-makers at the Fed, on Capitol Hill and in the new Bush administration to understand this fact. Gradually reducing interest rates, as the Fed has a penchant to do, is not sufficient to reverse the monetary deflation to which it has been subjecting the country over the past 18 months.
Unless the Fed begins to calibrate its open market operations by a commodity-price rule (my preference being a gold-price rule), it will continue to deny the economy sufficient liquidity to meet the demand for money. A gradual “glide path” to lower interest rates will only cause economic production to slow until the demand for money shrinks sufficiently to equate itself with the limited supply of money the Fed is providing by interest-rate targeting.
If one adds to this equation significant tax rate reductions and the Fed does not respond to accommodate the rising demand for money that surely will follow in their wake, it will continue to squeeze the economy in a deflationary vice.
The good news is that Mr. Greenspan has indicated our recent national obsession with retiring the national debt is over. It sounded like a sonic boom rolling across the nation’s capital as he knocked the pins out from under what had been a prevailing ill-conceived and counterproductive consensus that there is little room to cut tax rates because we should be on a crash course to retire the national debt.
This misguided notion has kept Congress m a stalemate over taxes for more than three years now, but Mr. Greenspan made it possible to break the stalemate when he told senators excessive budget surpluses are undesirable because, “just like excessive deficits, excessive surpluses distort the structure of private economic growth, and that’s bad:’ He emphasized that the best fiscal policy does not mindlessly seek the lowest possible level of debt in the shortest possible time, but rather seeks over the long run to maintain balance in the operating accounts of the government.
It is important to note that markets did not react much one way or the other to the chairman’s state,, ment, indicating investors already had factored in his support for a taxi rate reduction and his hints that interest rates would fall further. This means pressure to increase the size and expand the scope of the tax package currently under consideration is inevitable. Markets will demand it, and they would be disappointed if Congress fails to include some reduction in the cap# ital gains tax rate and some expansion of IRAs and 401(k) retirement accounts.
Mr. Greenspan broke the ice on partisan stalemate over taxes. Let us hope he doesn’t keep the economy in an economic deep freeze by maintaining deflationary monetary policy, which continues even as interest rates fall.