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A Conservative Proposal for Economic Recovery That Won't Work
Raymond Richman, 9/19/2010

(this is actually a joint posting by Howard Richman and Raymond Richman)

With the U.S. federal budget spiraling out of control due to Keynesian policies that are not even making a dent in unemployment, America is hungry for fiscally responsible economics. Mostly, what we hear from conservatives is the supply-siders' recommendations of more tax cuts, like the ones that made the budget deficits much worse during the GWBush years. But there is a fiscally-conservative school of economics: the monetarist school founded by Milton Friedman, the dissertation advisor of one of us (Raymond).

Monetarism recommends balanced monetary growth and balanced budgets in order to attain stable economic growth and avoid inflation and big recessions. It keeps long-term growth in mind while taking short-term economic fluctuations in stride.

On September 16, several conservatives with huge Republican-establishment credentials, proposed a monetarist solution to the current malaise in an op ed that nearly took up a full page in the Wall Street Journal. George P. Shultz (former Treasury Sec’y), Michael J. Boskin (Chair Council of Economic Advisors under first Bush), John F. Cogan (former Dep Director of Mgt and budget under Reagan), Allan Meltzer (prof of econ at CMU and reknown expert on Federal Reserve history),  and John F. Taylor (prof of econ at Stanford and undersec’y of Treas under GWBush), outlined their “Principles for Economic Survival.” In general, it was an excellent exposition of fiscally conservative policies for economic recovery. Unfortunately, it wouldn't work.

Shultz et al. are right in their claim that America’s anemic economic recovery has “largely been driven by economic policies that have deviated from proven fact-based principles.” They argue that people respond to incentives and disincentives, citing the work of  Nobel-prize-winner, Prof. Edward C. Prescott, who showed that as a result of higher taxes on earnings imposed in Europe from the 1970s to 1990s, (up 28% in Germany, France and Italy), hours worked fell by an average of 22%. And they point out how reckless Congress was and continues to be with huge sums wasted in support of banks and enterprises like GM, Chrysler, Fannie Mae and Freddie Mac. And they correctly point out the waste involved in the rebates of both the GW Bush and Obama administrations.

Unfortunately they say nothing about policies that would correct the enormous trade deficits that have cost the U.S. millions of manufacturing jobs, worsened the distribution of income, and made our current declared enemy, China, strong. American corporations find it very profitable to outsource their production to countries like China and have little incentive to invest at home.

We believe we should make balanced trade our policy, not free trade. We consider ourselves conservatives but it is not necessary to believe in free trade which is not economics but ideology as we have shown in our book, Trading Away Our Future (Ideal Taxes Assn, 2008) and repeatedly since then.

They blame the policy of low interest rates, embraced by the Fed under Greenspan and Bernanke, for stimulating the housing bubble but fail to mention that the low U.S. long-term interest rates were not caused by the Fed, but by the forced inflow of financial savings from the governments practicing currency manipulation as part of their mercantilist policies, designed to perpetuate trade surpluses with the United States. In fact, they completely ignore trade, apparently not realizing that President Obama's Keynesian policies are failing due to his failure to control the trade deficit.

The fact is that neither Keynesianism, nor supply-side economics, nor monetarism will work in a country whose trade deficit is being manipulated by foreign governments. On the other hand, as we noted in the American Thinker (Keynesian borrowing won't solve our economic problems), the strategy of monetarism (balanced monetary growth combined with balanced budgets) would produce stable growth if a new balanced trade rule is added, producing what we call balanced trade monetarism. We wrote:

The new balanced trade rule is necessary in order to respond to modern mercantilism, the economic policy that maximizes exports and minimizes imports in order to gain market share from trading partners. The latest evidence is the increase in China's subsidies to exporters which has not yet evoked a response from the U.S. government even though China exports four times as much as it imports from the United States and promised to forego export subsidies when it joined the WTO.

China and the other mercantilist governments have been perpetuating and increasing the U.S. trade deficits by buying U.S. financial assets with the dollars earned from their trade surpluses with the United States. For over a decade, American banks passed along the flow of foreign savings to American consumers, offering ever-riskier loans in order to get a high return. But when American consumers could no longer afford the payments, banks went bankrupt and the resulting hole in worldwide demand is causing the worldwide recession.

If the U.S. government switched to balanced trade monetarism, the U.S. could quickly recover since there would be plenty of demand for American products if foreigners bought as much from the U.S. as the U.S. buys from them.

Shultz et al. accuse Greenspan and Bernanke of expanding the money supply overly much, causing the overly-low long-term interest rates that caused the house price bubble. This is simply not true. In fact, for much of the 1998-2006 period of the bubble, the monetary base (M1) was declining, and throughout the period, inflation was low. The Fed only controls short-term rates, not long-term rates. And the overly-low long-term rates were directly caused by the inflow of foreign savings that accompanies unbalanced trade.

While it is true that the Fed could have taken leadership to get the federal government to insist upon balanced trade, they could not have counteracted the actions of the mercantilist central banks by themselves. For example, they could not have purchased Chinese RMB, to counteract the People's Bank of China's purchase of dollars, because they did not have access to those RMB, and if they had found a way to purchase them, the Chinese central bank would not have let them buy Chinese long-term bonds, which are off-limits to foreigners. The Chinese government is fine with its central bank purchasing American bonds, but does not permit reciprocity.

Other than that, Shultz et al. were quite good in their recommendations. Like us, they opposed the arbitrary bailouts of banks and other financial institutions, the massive purchases of long-term debt by the Fed, the temporary stimuli like the 2008 tax rebate and 2009 Economic Recovery Act, cash for clunkers, credits for first-time home buyers, and the health care bill which imposed taxes on savings and investment. They denounced the complex regulations in the 2010 financial reform bill which were left to administrators to spell out, transferring legislative powers to the executive. They denounced the increased federal spending which grew as a percent of GDP to  24% currently, up sharply from 18% in 2000.

How do they propose to grow the economy?

First, they call for a moratorium on changes to the tax code, although they admit that U.S. economic problems are partly caused by our overly high corporate income tax.

Second, they advocate balancing the federal budget by reducing spending, including rescinding unspent TARP and stimulus funds, canceling the subsidies in the health care bill, restoring the Constitutional role of the states and the Constitutional limits on the powers of the federal government.

Third, they advocate reducing the growth of Social Security and health-care entitlements. They urge more costs by the patient when making health care purchases, more health plan options, and more competition. They would start by repealing the new health care law.

Fourth, they advocate that there be a three year moratorium on new regulations of businesses. They advocate closing down, not bailing out, Fannie Mae and Freddie Mac.

Fifth, they urge that monetary policy should be more rule-like. The Fed should announce and follow its rules, including a new rule for divesting its portfolio of mortgage-related securities.

These proposals are all reasonable. But then they show a woeful misunderstanding of international economics. They advocate a combination of fixed exchange rates and every country agreeing to target for inflation. Do they really think that trade flows are determined by differences in inflation (i.e., purchasing power parity)? Do they not understand that exchange rates are determined by supply and demand in currency markets and that the mercantilist countries manipulate those markets so that they get manufacturing investment while we do not? Do they not understand that when a country gets more investment than its trading partners, its currency should strengthen, whether or not it has inflation? The following graph, shows the low level of U.S. manufacturing investment over the last decade which has caused the U.S. trade deficit to grow despite a falling dollar since 2003 and our low rate of inflation:


Their advocacy of a multilateral agreement to control inflation is more of the internationalism that is killing the American economy. America has the ability to solve its economic problems without requiring a world government. All we have to do is to insist on balanced trade using the scaled tariffs that we recommend, which would be authorized by a special WTO rule for trade deficit countries. Such tariffs are scaled to the size of each of our trade deficits with each mercantilist country and would last only as long as trade with a particular country remains unbalanced.

Shultz et al. are on the right track. Like us, they believe that economic stability is best maintained through a combination of balanced monetary growth and balanced budgets, but, unlike us, they have not yet figured out why the Fed's balanced monetary growth policy has not worked since 1998. As a result, they have not figured out that a third plank needs to be added in order for monetarism to work in the presence of mercantilism, not just balanced monetary growth and balanced budgets, but also balanced trade.

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Comment by Dave, 9/20/2010:

"And they point out how reckless Congress was and continues to be with huge sums wasted in support of banks and enterprises like GM, Chrysler, Fannie Mae and Freddie Mac."

The government is about to sell it's shares in GM.  They saved that company.

Fannie and Freddie have kept 1 million homes from being foreclosed. And the private sector stopped lending to the home market.  So, without them, there wouldn't be a market for real estate.

If we want to create fiscal stimulus, we can restore dividends to the junior preferred holders of the GSEs.  $20 billion is held by community banks and the value of that preferred stock plummetted with Conservatorship.  That sucked $200 billion in lending out of the economy.  $2 billion in dividends will bring that lending back.

Response to this comment by Howard Richman, 9/20/2010:
Balancing trade would make automobile factories producing cars and trucks in the United States quite profitable and would lead to a boom in the plants that make automobile and truck parts in the United States.

Comment by Eric, 9/21/2010:

Thank God!  You fella's had the insight to articulate what I've been saying all along.  If you have a free market surrounded by mercantilist markets its like a feeding frenzy on the free market.  The American Enterprise Institute needs to wake up and realize we don't live in a vaccuum!

Comment by Michael McVahle, 7/27/2012:

Well written, but history has shown us an economic policy that worked, and in fact, propelled us into the position of being the strongest and largest economy on the planet.

There is an old saying, if it ain't broke, don't fix it. Yet, beginning in the 60's, we began to "fix" what was not broken, and the end result is an economy where instead of a fairly even spread of wealth across the classes, we have concentrated our wealth in the hands of a miniscule portion of the population.

We need to return to the econonmic and trade policies of the 50's, recreate the Office of Wage and Price Control, reinstate the profiteering laws that controled interest rates, and repeal the free trade agreements that we have entered into with other countries, and return to the tax structure of the 50's as well. 

We have a model that has demonstrated that it works for the country, not only enabled but mandated investment in job growth, and yet still allowed the creation of vast personal growth.

Why is this so difficult to understand? If too much wealth is held by too few people, and those people are allowed to invest that wealth overseas, then there is no money left in circulation to create new jobs.

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  • [An] extensive argument for balanced trade, and a program to achieve balanced trade is presented in Trading Away Our Future, by Raymond Richman, Howard Richman and Jesse Richman. “A minimum standard for ensuring that trade does benefit all is that trade should be relatively in balance.” [Balanced Trade entry]

    Journal of Economic Literature:

  • [Trading Away Our Future] Examines the costs and benefits of U.S. trade and tax policies. Discusses why trade deficits matter; root of the trade deficit; the “ostrich” and “eagles” attitudes; how to balance trade; taxation of capital gains; the real estate tax; the corporate income tax; solving the low savings problem; how to protect one’s assets; and a program for a strong America....

    Atlantic Economic Journal:

  • In Trading Away Our Future   Richman ... advocates the immediate adoption of a set of public policy proposal designed to reduce the trade deficit and increase domestic savings.... the set of public policy proposals is a wake-up call... [February 17, 2009 review by T.H. Cate]