A 3-D economic illusion

Posted: Nov 29, 2004 12:00 AM

Policymakers would do well to keep in mind a couple of universal truths when preparing to embark upon fundamental changes to long-standing programs and entrenched policies, such as creating personal retirement accounts and simplifying the federal tax code. One such truth is: What we don't know usually doesn't harm us nearly as much as what we think we know that isn't true.

Nowhere is this more evident than where debt, deficits and the dollar are concerned.
An entire belief structure, completely at odds with empirical evidence, has arisen about how debt, deficits and the value of the dollar affect the economy. The belief structure, which prescribes high taxes and floating currencies, was concocted by neo-Keynesian economists and popularized by pundits, politicians and Wall Street participants who scavenge academic scribbling in search of theological support for their own financial interests or political ideologies.

This economic belief structure about debt, deficits and the dollar - call it "3-D economics" - is grounded in two illusions: First, it believes a currency is just another commodity, and its value is set by foreign exchange markets according to the forces of supply and demand. As a Wall Street Journal editorial recently pointed out, however, "A currency isn't just another commodity, like wheat or copper." The dollar is a measure of value not intrinsically valuable itself.

The dollar is a unit of measure - a numeraire - and the currency, when calibrated against this unit of measure, provides a store of value. Foreign exchange markets merely reflect the changes in demand for a currency, the supply of which is established by central banks, in our case the Fed, which has monopoly power over the issuance of fiat U.S. dollars.

  Shrinking demand for the dollar manifested in a falling foreign-exchange rate can be one indirect signal that the central bank is running too loose a monetary policy, generating inflation and depreciating the dollar's value. However, since the Fed has this monopoly power over the issuance of our fiat currency, only the Fed can alter the supply of dollars and ultimately the dollar's value. It is impossible for government to correct the monetary error or rectify the declining economic competitiveness emanating from the error by manipulating foreign exchange markets (whether by word or deed), by raising taxes or by any other fiscal policy.

The second unfounded conviction on which 3-D economics rests is an update of Thomas Jefferson's "bugaboo" against public borrowing in which public debt is seen as an unqualified evil because it "crowds out" private investment and unjustifiably burdens future generations with paying the cost of consumption enjoyed by the current generation. Jefferson's rival, Alexander Hamilton, believed that public debt prudently incurred and properly managed could be a "blessing." Wisely invested to help cover short-term deficits resulting from adopting personal retirement accounts and reforming the tax code, public borrowing can, in fact, generate a more bountiful future in which a fraction of the increased bounty can be - and enthusiastically will be - devoted voluntarily by future generations to retiring the debt because the reforms leave them much better off. Read Ron Chernow's outstanding biography of Hamilton.

These dual misconceptions lead 3-D economists into an entire chain of logically fallacious reasoning, to wit, deficits raise interest rates because they lower the supply of savings available for investment, in turn reducing investment and consequently lowering economic growth. Fed Chairman Alan Greenspan committed the fallacy recently when he said, "Reducing the federal budget deficit (or preferably moving it to surplus) appears to be the most effective action that could be taken to augment domestic saving." In fact, a host of studies demonstrate that deficits in their current range have no discernable impact on interest rates, and the so-called "saving pool" is far from stagnant, evidencing rising and falling tides quite sensitive to changes in the after-tax return to capital, which is profoundly affected by the tax code and regulatory policies.

Indeed, the belief structure of "3-D economics" is so completely at odds with the data that it borders on superstition, yet it has entrenched itself in nearly every administration for the past 35 years. Only rarely since John Kennedy was president has that prevailing "wisdom" been exorcised, and then only episodically and temporarily by a strong-willed president with a coherent, reality-based economic belief structure of his own at odds with the 3-D illusion, e.g., Ronald Reagan, John F. Kennedy and - hopefully - George W. Bush.

Already economists, politicians and pundits are analyzing the challenges of personal retirement accounts and tax reform through 3-D-economic lenses. They remain obsessed with deficits, which by historical standards are unproblematic. With annual deficits at 3.5 percent of GDP and falling, debt as a share of the economy soon will begin to decline again. Unless Congress goes on another spending binge, the Congressional Budget Office projects that the Bush tax cuts can be made permanent and the budget still come into balance through economic growth. But the 3-D economists are deceiving the American public by arguing that federal spending inevitably will grow to a quarter and eventually to a third of national income by midcentury.

Possessed of the 3-D conventional economic wisdom, a contingent of pundits left and right are pressuring the president in the name of "fiscal responsibility" and "dollar stability" to keep personal retirement accounts small and to cut future benefits, raise the retirement age and increase payroll taxes to pay the so-called "transition" costs. If the president allows bureaucrats or members of Congress to negotiate with themselves and then lead with the administration's fallback position, the legacy opportunity of tax reform and personal retirement accounts will be lost.

Presidents Reagan and Kennedy proved that determined leadership from the top can conquer the paralysis and timidity of prevailing conventional wisdom. Now is the time for clarity, which means single-entry bookkeeping and those 3-D lenses that so distort reality must go once and for all.