09.30.2010 0

Too Hot Not to Note: Sen. Kyl Gets Taxes Right, But What About The Dollar?

  • On: 10/25/2010 09:23:54
  • In: Economy
  • ALG Editor’s Note: In the following featured column from Forbes.com, Paul Hoffmeister finds something important missing from Senator Jon Kyl’s “Growth Agenda”:

    Sen. Kyl Gets Taxes Right, But What About The Dollar?

    By Paul Hoffmeister

    In the Oct. 13 issue of The Wall Street Journal, Sen. Jon Kyl, R-Ariz., observed that President Barack Obama’s Keynesian economic program had failed, and that pro-growth tax reforms offered the best route to economic recovery. The senator then offered his “Growth Agenda for America,” which amounts to an excellent plan for fixing fiscal and regulatory policy.

    Unfortunately the “Growth Agenda” won’t work unless America’s badly broken monetary policy is repaired at the same time. Starting where we are now, implementing the “Growth Agenda” without monetary reforms would cruelly disappoint the American people and discredit supply-side economics.

    Sen. Kyl proposes limiting government spending to 18% to 19% of GDP, lowering the corporate tax rate, flattening income tax rates, lowering tax rates across the board and increasing congressional oversight of regulatory overreach. However, Kyl’s plan ignores the elephant in the room: monetary policy. In terms of their power to affect the economy, if regulations have an impact of 1, then taxes have an impact of 10 and money has an impact of 100.

    The primary cause of our accumulated economic problems is the deteriorating monetary environment. Utilizing a flawed interest-rate targeting mechanism, the Federal Reserve raised interest rates between 2004 and 2006 and then maintained an inverted yield curve into mid-2007, all in an effort to slow the powerful growth that was ignited by the 2003 tax cuts.

    Because rising interest rates are ineffective in protecting the value of the dollar, the dollar weakened as the gold price rose from $400 to nearly $800, signaling emerging inflationary pressures that showed up quickly in higher prices for food and gas. So while job prospects dwindled and wages stagnated, living costs rose, the combination of which produced a consumer squeeze.

    As a result defaults increased rapidly on mortgage-related debt, especially subprime debt. To give the economy some support, President Bush passed a $152 billion stimulus bill in early 2008, but it didn’t stimulate. With defaults continuing to rise, the values of mortgage-backed securities declined significantly, which depleted the capital bases of major financial institutions, causing some of them to become insolvent throughout 2008.

    The financial institutions that wrote insurance policies (called credit default swaps) against such defaults suffered additionally severe losses. Then in October 2008, in an unprecedented step, the Federal Reserve started paying member banks above-market interest rates on reserves deposited at the central bank, arguably disincentivizing banks to lend when their loans were more important than ever.

    This chain of events culminated in a near meltdown of the global financial industry and an economic contraction. The 2004-2008 economic record illustrates that any positive benefits from the Bush tax cuts were overwhelmed by the disastrous domino effect caused by the Federal Reserve’s monetary policies and neglect of the dollar.

    Today credit markets have normalized, thanks in part to improvements in mark-to-market accounting rules in April 2009. But a stagnant growth trajectory continues. The Obama administration and Democratic Congress passed the astronomical $787 billion stimulus bill that, once again, did not stimulate, and the Federal Reserve has been inflating the economy and weakening the dollar even more.

    The Federal Reserve’s experiment with inflationism will end badly. Bernanke and Co. are attempting to flood the economy with more liquidity to avoid a supposed deflationary spiral. But prolonged deflation occurs when currencies are excessively strong, like the yen during the 1990s, which contributed to Japan’s lost decade.

    The dollar, however, is excessively weak, which is indicative of incipient inflation. In typical fashion Federal Reserve officials are behind the curve. The deflationary pressures the economy experienced during 2008 and 2009 were only temporary phenomena caused by producers and retailers slashing prices to quickly liquidate goods to equilibrate to a new, slower-growth outlook.

    Given the fact that the gold price has risen from approximately $800 an ounce in November 2008 to more than $1,350 today (in response to the Federal Reserve’s quantitative easing), inflationary pressures are emerging that will dwarf those created between 2004 and 2007. Cotton prices, now at 140-year highs, are an example of what’s to come.

    The electorate in its collective wisdom is astute enough to know that monetary reform is the optimal approach to deal with today’s economic crisis. The Tea Party, which sprang up in reaction to last year’s stimulus bill and the inflationist measures used to address the financial crisis, is the personification of the frustration in grassroots America over the recent Keynesian failures.

    Ron Paul, the only presidential candidate in 2008 to discuss the necessity of monetary reform, set Republican fundraising records even though he had little chance of winning the nomination. Still Sen. Kyl’s economic plan does not even mention the maligned dollar or propose to reevaluate the Federal Reserve’s monetary management. Have Republican leaders forgotten the ideas behind the Republican renaissance of the 1980s?

    The twin pillars of the Reagan Revolution were Art Laffer’s pro-growth tax policies to reduce unemployment and Robert Mundell’s prescription for strong, stable money to minimize the chaos of monetary distortions and maximize confidence in long-term commercial contracts. Monetary reform remains the other half of the still incomplete Reagan Revolution.

    The Republican Party, well-versed on fiscal economics, has been outpointing the Democratic Party on tax issues for the last 30 years. But it must still master monetary economics. A congressional mandate for the Federal Reserve to abandon its interest-rate-targeting policies and to instead adopt a price-based rule targeting a strong, stable dollar would be a political coup de grâce and safeguard the forces of economic growth.

    Now that is a “Growth Agenda for America.”

    Paul Hoffmeister is the chief economist at Bretton Woods Research, LLC. He can be reached at phoffmeister@brettonwoodsresearch.com.

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