July 22, 1993
Lawrence A. Kudlow, Richard K. Vedder, Lowell E. Gallaway, Stephen J. Moore, Steve H. Hanke, Richard Keith Armey

Contents

• Lawrence Kudlow, Senior Managing Director and Chief Economist Bear Stearns & Company, Inc.
• Richard Vedder, Distinguished Professor of Economics Ohio University
• Lowell Gallaway, Distinguished Professor of Economics Ohio University
• Stephen Moore, Senior Economist Joint Economic Committee, U.S. Congress
• Steve Hanke, Distinguished Professor of Applied Economics John Hopkins University

Lawrence Kudlow

I want to focus a lot on the book [Out of Work: Unemployment and Government in Twentieth-Century America]. I think it is an excellent book and I think it is an important book. And one which deserves to be made as visible as possible in the months ahead. I think it is an excellent restatement of the Austrian free-market tradition and the notion that microeconomics is really the heart of macroeconomics, and, of course, in particular the strength of the private market economy and the folly of government activism which always fights the market economy. And also I want to note that there is a lot of good economic history in here. Steve Moore mentioned some of the quotes that Lowell and Richard put together on the commentary on Reagan’s tax cuts, but there is just a lot of good century-long history in here, which is something I think is important because I think that the economics profession does not do nearly enough insofar as reviewing history at least insofar as free-market principals are concerned.

In addition, I think the book should be commended because it focuses on the labor market. We don’t really focus on the labor market any more. In the U.S. in recent years, when we have an unemployment problem we just tend to throw some money at it. I think, in fact, in the last twelve or eighteen months, under two presidents, we’ve had three, if not four, but three unemployment compensation increases. And that is about as much as anybody ever thinks about it. We don’t think of labor as a market where there is a price clearing supply and demand equilibrium point. So, in that respect, it’s a very important book. We do focus on credit markets, stock markets, goods and asset markets. And we probably had some improvement in policy analysis if not actual policies.

But I think the labor market debates have pretty much been moribund until, hopefully, this book ventilates them. Now in terms of the analytic views, the basic analytic, the adjusted real wage, money wages divided by either the CPI or the PPI, and then all that divided by the rate of productivity. I think it is a good analytic. I first saw it close to ten years ago when I was still in the government, and liked it then because it approximates real labor unit costs, and that is a very old class way to look at the economy.

And furthermore, the flipside side of this—the reciprocal—is profits. And one of the things this book does, is it discusses profits, and as a non-Keynesian, I strongly believe that profits drive the economy. Firms making money have the resources to expand production, investment, employment and so forth. Firms losing money have to contract. And in the aggregate when the majority of firms are profitable, and that is in my judgement the best indicator of economic expansion. And I think the game in many respects, the game of economic forecasting is just that simple—follow profits, or if you must, cash flows, or other derivatives of business revenues. Business creates jobs, and jobs then provide the wherewithal for income, saving, investment and so-forth. So I think all of these old-fashioned notions, that there is a labor market where labor market prices, both pre-tax and after tax, affect the supply of labor and the demand for labor. And I think that we ought to go back to that because as Steve Moore indicated, public policies under many presidents in recent decades have completely ignored the workings of this market. All of that said, I think there are some very good, important issues here, and I mentioned profits, and I mentioned the adjusted real wage.

One of the issues—it is a very good forecasting tool—it sort of is a leading indicator or a coincident indicator of profits. I said profits are the reciprocal, but you need to have some analytics to get to the profits. Profits being the spread of prices versus cost, but all of that is neatly subsumed by the adjusted real wage. If my memory serves me, we used this in OMB and CEA and Treasury in the early ’80s to defend the notion that we were going to have an economic expansion after everybody was trashing the president’s program because of the lingering effects of the early ’80s reciprocation. This measure was pointing to enhance profitability which in turn was pointing to economic expansion, and I believe the turning point was late ’82, early ’83 for this measure of the adjusted real wage, so things are pretty good.

Now Richard and Lowell have worked on this and massaged it, we’ve got now, I guess, a short form and a long form. The longer form has six or seven year lags. But that’s all right, that kind of multi-varied work is useful if more complicated, it doesn’t change the basic analytic. And I feel that in the forecasting profession, rather than these top-down, demand-side driven econometric models, probably the best known being the data resources DRI model, this kind of work is far more useful, far more explanatory, and also, frankly, far more accurate. The chart work and the data work is excellent in this book. Excellent. And books with this kind of broad sweep normally don’t engage in any quantitative analysis besides a few cursory pictures. This one goes into great detail, and I am not a quant-jockey particularly, but it was easy for me to get through it, so I think it is quite useful from that standpoint.

Now, all that said, I want to note an interesting, practical, real-world issue without denigrating the broad analysis Steve Moore has provided us with respect to the longer-term depressive effects on the American economy for misguided tax policies.

I look at the model and I see a pretty strong recovery coming up. We have had a very mediocre recovery in the U.S. for the last year or two, but if we go through this, it tells me a bunch of things which run almost counter-conventional as far as the doom and gloom surrounding the outlook of the U.S. economic growth.

Now, let me note, I’ve talked about profits. U.S. non-financial business profits are up $90 billion since the bottom, which was roughly in late ’91. Business revenues are up $150 billion. Cash flows are up about $100 billion through the first quarter of 1993. Economic profits, as measured by the national accounts and adjusting properly for inventories and capital consumption, are up about 12 percent over a year ago. All of that does not suggest recessions, just expansion. If I work through the adjusted real wage, what we find is, first of all, money wages are very moderate, growing and not more than 3 percent by any measure in the manufacturing sector by less than that. The inflation rate is edging up, but it’s still no higher than 3 percent. And the year-to-year change in productivity at the moment is roughly 2 percent. If I use manufacturing and I use producer prices, productivity is rising by close to 3.5 percent, producing prices are only rising by slightly less than two percent. So this calculation, this analytic, adjusted real wages since mid-1991, has fallen by 3.4 percent or 2.3 percent annual rate of decline for about two years. If I substitute the producer price index as a measure of inflation, so I can get a fix on the wage crossing the manufacturing sector, it’s even better. Since mid to late ’91 real wages have declined by 4.7 percent or 3.8 percent at an annual rate. So if the price or cost of labor declines, the demand will rise.

And I believe, as a result of this, a strong burst of job creation in the next two to four quarters. We will see a substantial decline of the unemployment rate, and we’re going to see a second leg of the profits expansion. In fact the stock market has been forecasting the profits expansion since late 1990. And although the rate of increase of the stock market has slowed down in the last ninety days, (well, it should with a big tax bill in front of it) not withstanding that, simple calculations using the stock market suggest we have another two to four quarters to go before corporate profits peak. So, I think it is a very interesting take, a real-world application—I regard myself as someone operating and applying this stuff. Steve Hanke is the professor of applied economics, and I’m the user of applied. I’m the applier of economics. I do it for a living, more or less. To me, it looks like a fairly rosy scenario. Not forever mind you, but probably for the next couple of quarters. I might give it a year before the contractionary fiscal policies take effect. I might also add, since the Galloway-Vedder book discusses monetary policy.

We may be at a period where we get one of these unanticipated inflation bursts. This was discussed in two ways in the book, and quite interestingly. The middle 1960s showed the burst of unanticipated inflation, which helped things quite a bit in the short run, though it damaged them enormously in the longer run. In the early and mid-1980s, twenty years later, we had an unanticipated burst of deflation, or disinflation. Commodities deflated for about ten years, so I’m not bashful. And that had a very negative impact to the short run, but an extremely positive impact on the long run—one of the contributing factors to the ’92 month economic expansion.

Here in 1993, mid-’93, the price of gold is close to $400 per ounce. That tells me inflation expectations and actual inflation is rising not falling. And also, if I look at the balance sheet of our central bank, their balance sheet as defined by reserve bank credit, unadjusted high-powered money is rising by 15 percent year-on-year, or the change of the dollar level that assets is about $44 or $45 billion. Those are both big numbers. Fifteen percent growth, a $45 billion yearly change, in fact. Those are, I believe, record increases through the post-world war period. And that balance sheet is expanding, not contracting. It’s accelerating, not decelerating. So, I’m interested in this.

The reason I say unanticipated inflation is that inflation expectations are predominantly very low at the moment as very low as they have been for many years. And most market participants, most investors, and nearly all business people, at least in the short run, operate on adaptive expectations. That is what happened in the recent past, and what will go on happening. The rational expectations argument, or the forward expectations argument, is still, I think, a small kernel of economists, it is not a widespread view. Furthermore, the only unambiguous inflation sign right now is the $60 or $70 gold increase. And very few people rely on gold as an inflation indicator. And also, very few people use the balance sheet of the federal reserve. Most people look at M2 nowadays.

So, I think you’ve got unanticipated inflation. I think you have very wide profit margins, and I think you have low and possibly declining wage costs, which under this model, at least for some short period of time, all augers for stronger economic growth and greater job creation and lower unemployment. And in fact, I have used this in conversations with a bunch of Republican policy leaders in Congress and out of Congress to try to at least give them some perspective that there are good reasons to be concerned about the long-run health of the American economy in view of the tax bill and other measures now before the Congress. But that’s the long-run view. In the short-run, pessimists with respect to the president’s new economic plan, pessimists may be very disappointed. Indeed, I’ve been somewhat glib in saying that the economy may rise, and Clinton’s stock may rise a lot in the next six or nine months, though the stock market, which has already discounted this may actually fall. In fact, I sort of see it—Clinton’s stock fell for the first six months the year the stock market went up. I think when his stock starts rising, the stock market’s going to decline. But his stock, if you will, as an approval rating, is to some extent predicated on economic performance, and I think that’s going to improve. So I would probably buy Clinton’s stock right in here, he’s down in the mid-thirties. He’s actually running neck to neck with IBM. I would not buy IBM; I would buy Clinton, and I’d put a cover on it in a high-40s.

Now, what does not remind me of the early to mid- 60s, is U.S. tax policy, and I want to talk a little bit about that. And, in general, I want to try to expand the model, but put some different emphasis on the model. As you might expect, I cannot resist a tax discussion when we get to macroeconomic policy. Clinton’s tax policy, of course, is highly contractionary. Across the board tax increases, lessly aimed at reducing the budget deficit in Steve Morris’ outline, and I agree with Moore, that there’s no economic logic behind this. I’ve often asked in the last six months “where are the true Keynesians now that we need them?” because this thing really defies almost all logic.

Now, Vedder and Gallaway do an excellent job on the tax question, relating it to their model in the chapter, The Camelot Years. And of course, I must read the quote, which being published on page 202, which my friend, Rush Limbaugh, published on his television show last week, or the week before last. Here it’s called a public speech—So it’s actually the Economics Club of New York. It isn’t true that Jack Kemp wrote it because Jack was only about 18 years old. None of us had educated him yet. I don’t know who wrote this thing to be honest with you.

That is from Kennedy; that is pretty awesome. Maybe Mellon wrote it in his second or third incarnation, I don’t know. It’s a remarkable quote, and I want to raise that because as well as the book does in evaluating the real wage model in the ’60s, it does not do as well as it should in evaluating the model in some earlier periods. And I have some specifics here. This is what I call “tough love.” It’s not really a criticism because I believe they agree with my views on tax policy. There is a point in 1914, and discussion in 1914. Well, 1914 was an interesting year. It was kind of the beginning to the end of the long period of prosperity in this country. [Dr. Stephen Hanke: “The gold standard.”] Thank you Steven. One of my favorite presidents launched that. One of the great underrated presidents of this country, Ulysses S. Grant. The trouble is he wrote his own biography, and unlike modern presidents he was critical of himself, and hence historians have just used that down through the years. But the one thing the guy did is he put us back on the gold standard. We had no income taxes or regulations to speak of in those days, and the post-Civil War to World War I period was arguably the best burst of prosperity this or any other large nation has ever known.

1914, Woodrow Wilson was president. I graduated one hundred years ago from the Woodrow Wilson School of Princeton, so that’s another take. Our authors can’t figure out why there’s a slump in productivity and a rise in real wages. And so their model sort of picks this up. Well, I have an answer; the income tax was created in 1913, and it came out of the blue. And it wasn’t the payroll withholding tax. That was not until 1943. But the income tax which was done in those days, I believe in either quarterly or semi-annual payments. And that was before the war. The United States did not enter the war until 1918 with people. By 1916 we knew we were going in, although Wilson wouldn’t admit it. This is 1914. This is the first Tax-and-Spend Democrat, if you will. It actually has a lot of similarities. And another reason: Woodrow Wilson and his wife Edith. Edie basically ran the country in 1919 and 1920 because Woody blacked out at that point. So it’s not unlike Bill and Hillary.

But again, here’s a tax shock affecting productivity, which then runs your model too high, which dampens employment, and raises the unemployment rate. So I think taxes are the missing link. Also, the Hoover-FDR chapter, I mean, fellows, you’ve got to go back and rewrite that. I’ll help you do it, but you’ve got to get—I mean look, we’re talking first of all serious tax cuts in the 20s. There’s very little mention of the tax cuts. A good take on the ’20-’21 crash and the recovery. But you know, we had multiple tax relief. We took the World War I tax rates down from about 80 or 90 percent back to 25 percent. And this, of course, unlocked a burst of productivity and technology. You have your Smithian capital formation and your Schumpeterian technological. I mean we just blasted off. The ’20s were really the beginning of the modern era. We had consumer products; we had serious stock market; we had tremendous expansion; we did not have any inflation. So, you need to go back and spend some more time on that. I agree with you in your grouping of Hoover and FDR. I love that part. That is Bush-Clinton writ large, alright. That is just wonderful.

Hoover deliver Republican? He’s a good guy. He’s a great engineer. He had a great heart. He was out there doing food relief programs, and all the rest, but he was really the first modern Keynesian, before we thought in those terms. And the tax increase, the first tax hike of the ’30s occurred under Hoover, and it was a whopper. From about 25 to 60 percent, as I recall. And in case that didn’t slam the economy, once he had it on its knees, he stood there kicking it by passing the Smoot-Holly-Tariff, which was a tax on international transactions, otherwise known as tariffs. Now you’ve got the tariff story, you get an “A” for that. And you got the tax story, you get an “A” for that. You just didn’t get the prior lead-up in the 1920s so I dropped that earlier chapter down to a “C-” in an otherwise “A+” work.

Now, also in the 1970s, you guys do a pretty good job in the ’70s. And here’s where the third inflation play comes in. But you’ve got to remember the tax bracket-creep phenomenon, which also undermined productivity substantially. You hit a home run in the ’80s; you got the whole story right. You even mentioned some supply-siders by name, although I understand one of them is attacking you. But that’s all right: he attacks everybody. You just have to sort of get along with that. That one is a candidate for group therapy, not economic analysis, so don’t fret about that; you’ve got the ’80s story completely right. But look, in a serious way, what I want to do is take this model, all right, you’ve got the numerator is wage rates and inflation, the denominator is productivity.

One of my points here is that taxes affect all three variables. Now, taxes affect wages because people whose after tax wage income declines, tend to have a higher pre-tax demand for wage income. And I think you talked about that in the inflation context, and I totally agree with you. But it’s also true in a tax context. We’re going to see that this time around. In fact, Steve Moore’s rendition of the Social Security rises, is one of the reasons why, I think, we still haven’t gotten labor prices down to where they ought to be. So that’s one point.

The second point is, taxes affect inflation, another of your key variables. Give me the same stock of money, and a higher tax regime, and you reduce the availability of goods. Therefore, the existing stock of money is now chasing fewer goods, i.e., inflation.

Also, I think in a very classical sense, and I’ll hark back to Arthur Laffer on this point—rising tax rates reduce the usefulness of money, because rates have returned, declined across the board, with particularly invested materials. Therefore, people don’t like to hold money. They like to hold hard assets. Laffer called this the “moneyness of money,”; it’s a great line, I believe he invented it, and I think it still holds. So here’s where taxes affect your numerator. Now, on the denominator, I see you have a direct hit. Taxes affect productivity. You talk about that explicitly in your book, so this is in praise, not blame. And I think it’s an important point. Taxation affects productivity. Very important point. And in fact, if I can expand on that, and go back to the old K/L ratio, capital/labor ratio, my point is your paradigm, the adjusted real wage is not an austerity paradigm, it’s a growth paradigm—provided we understand that underpinning this in economic policy terms, is taxes and regulations, as well as a straight wage inflation model. Labor cannot exist without capital. Indeed, if the Clintonites understood this, they’d have a much better take. It is precisely rising capital formation, which improves labor, gives them technology, gives them the wherewithal, gives them the tools, gives them the resources to go to work. And by the same token, capital cannot exist without labor.

The entrepreneur in the Shumpeterian model or the business manager, in more recent models, needs people to work whether they’re white collar or blue collar. And we need them to be educated and we need them to be equipped. We need them to be healthy, etc., etc. So capital/labor stand together. And I believe the K/L ratio has a lot to do with the productivity denominator in your calculation. Now you know that and I know that, I’m just trying to emphasize that, because I think it is possible that somebody could look at this and tell you “Well, okay, what’s the moral of the story? Bash down wage costs, and capitalists will get rich, and we’ll all grow and be prosperous.” That is really not what you’re saying, that is not your intent, nor is that your statement, but I think an expanded analytic underneath your own analytic with greater discussion of the impact of tax rates, and I might add, taxes on labor, as Steve Moore pointed out. The Social Security payroll tax constellation, the unemployment compensation, the things that Steve Hanke talked about, with respect to the European story. All these things are going to affect your adjusted real wage. I think we probably all should focus on how this tax and productivity, or let me just call it tax and deregulatory policy, impact on productivity. We probably need to look carefully at changes in participation rates and employment population rates to try to quantify this stuff.

One of the more disappointing aspects to me was that the productivity rates during the Reagan years didn’t do better. They went from minus to plus two, but they didn’t get threes and fours and fives that the earlier decades had when your model really worked. I suspect it has to do with the fact that even while income taxes were going down, Social Security taxes were going up, and I, for one, regard that payroll tax story as extremely punitive. I wish I could get policymakers in either party to look at it. They just don’t want to touch it, and I think that’s really a problem. So, all that said, the paradigm works, has a great forecasting track record. It’s an early warning signal of profitability and expansion. It summarizes, however, I think more than one might guess. It summarizes through both the numerator and the denominator, tax policies, and other savings investment policies, such as government spending and regulations and payrolls, and, of course, capital gains and the income tax. And I think if we flush that out, we have a growth model.

Now, two other points. Returning to the practical, I loved your long-run unemployment rate curves. I love them and the idea of defining the unemployment rate as the natural rate. Now, I take it that you believe that sort of natural rate through the ’80s is about 7 percent. Is that fair? More or less, okay. Let’s say in the ’70s and ’80s, the things rising to about 7 percent in one of your long curves. And I think your view is the former natural rate was somewhere between 4 and 5 percent. Now that’s interesting to me. Today, the unemployment rate is 7 percent. It got down to 5 percent, it was 5.2% in 1989; Reagan’s last fiscal year, Bush’s first election year.

But I want to look at the unemployment rate in terms of the budget deficit. This is an issue that Booms, Cannon and I used to talk about in the early ’80s where this was this notion that the budget deficit could be solved if we got the unemployment rate down. Because various economic sensitivity analyses of the interaction between the economy and the budget showed that when unemployment was declining, revenues were rising, the demand for spending was falling, and therefore the budget would move in toward balance. And this was the genesis of these sort of full employment budget models.

Now, none of that ever worked the way anyone wanted it to work, but there’s enough of a grain of truth in that to let me pursue it in terms of your book, which is a story about unemployment. You don’t talk much about the budget deficit as a policy problem. You talk about it more in the Keynesian paradigm, which is fine. But look, let’s suppose we use this model of the adjusted real wage, and we decide as a matter of national policy, we wanted to get the unemployment rate back to 5 percent or even less. “The old Truman.” But we’re not going to do it in a Truman, Heller, Hanson, Okun, whoever else you trash in here, which I enjoyed thoroughly. I’ve sort of forgotten about Albert Hanson, by the way. That was a good one. He’s a “golden oldie.” Some of that we want to do in a Vedder, Galloway, growth, Hanke, Moore, Kudlow, Niskanen, Kemp, Armey, right way to do it. In other words, I want to turn austerity into growth.

So we decide, okay, we want to hold inflation steady. We want to get as zero-inflation as possible. We want to let money wages do what they’re going to do in some equilibrium. But we don’t want government programs to interfere and boost their price. What we really want to do is get that denominator up as much as possible, because that’s where the real torque in the model can come to, if it’s a growth model.

So we adopt policies to roll back spending and enforce it. We index where we should be indexing capital gains and depreciation allowances. We get the payroll tax down, and we prohibit any income tax. We do all the things Steve Moore and Dick Armey want us to do. And at the end of the day, we get the unemployment rate down to 5 percent. Now when I go to the Congressional Budget Office, and I look at their economic sensitivity analysis, a two percentage rate reduction in the unemployment rate, according to them would drop the budget deficit by $275 some odd billion by the end of five years. That’s their stuff. So, if I want to implement Vedder-Gallaway, adopt the right policies, which will lower the adjusted real wage, and therefore reduce the unemployment rate to it’s long run century five percent zone, I’m going to balance the budget. In theory. Now, this interests me, obviously, since I’m dwelling on it. It interests me a lot because a lot of people in the mid-’80s, led by my former employer David Stockton, talked about something called the structural budget deficit. And I feel about the structural budget deficit the way you guys feel about the structural unemployment rate, or the core-inflation rate, which was the price analog. I think it’s garbage: utter nonsense. There’s no such thing as a structural deficit. There’s a deficit because: 1.) Fiscal policies are too expansionary on the spending side; and, 2.) The economy is under performing as it was illustrated by the unemployment rate trend. If I could solve those two issues, I wouldn’t have any deficit at all, structural or otherwise.

One reason people said we have a structural deficit, is the entitlements that are gobbling up budgetary resources, health care, in particular, Medicare and Medicaid. Well, I haven’t done enough work on this but I am going to do some more work on it because in the last five years, the eligibility to the benefits from Medicare and Medicaid have expanded so substantially in recent Congresses that these things are looking and behaving a lot more like counter-cyclical, anti-recession programs than they used to. And that is new. And that is something we should think about. It is part of the Hillary health care plan.

In other words, most large states in this country are being driven into fiscal ruin or economic ruin if they raise taxes for the simple reason that mandated Medicaid payments are forced upon them in enormous growing volume. And that coincides with the onset of a long flat patch in our economy, which basically begins in ’89, and continued through ’91 or ’92, and you might even argue ’93. It’s spending patterns of Medicaid and Medicare, the spending patterns that is the timing of the rates of change are looking more and more like the old counter-cyclical programs: unemployment compensation, AFDC, SSI, food stamps. And then as Steve Moore said, we’ve layered quite a bit on to that nutrition stuff. Plus let’s not forget Head Start which looks a lot like the same story. In other words, what I am saying is, we have taken social insurance health programs, Medicare and Medicaid, we have expanded their eligibility so far beyond the definition of an insurance program that they now look like other forms of counterciprocal spending.

Okay, politically, I may or may not be able to ever change that, and if it is changed, I may not like the change, i.e., Hillary’s nationalization with her little Soviet-style health care communards that she’s talking about, that’s some sort of suped-up HMOs, which aren’t really HMOs at all. They’re communards.

Anyway, maybe I ought to go back to my growth model as newly defined by Vedder and Gallaway, and say the real issue here is to focus on labor markets and the unemployment rate, and particularly the productivity part so if I can grow the economy. I am going to reduce the spending of these other programs. And if I grow the economy, and I get the unemployment rate down, I am going to raise revenues, such that the combination of slower spending and higher revenues will generate $150 billion per one percentage point unemployment rate cut over five years by the fifth year. And if I get the unemployment rate down to 5 percent from 7 percent, I’ve got myself a balanced budget, or you know, we want to leave a little over, it’s too much money. I mean, I’m a “bond salesman,” I’ve got to sell something out there, so we don’t want to eliminate the deficit entirely. But basically, it will be gone from the public consciousness.

So there’s a new take based on your model. I’ve now brought you into the budget debate. The final point: What is Clinton doing? Well, Clinton is Hoover. He isn’t Roosevelt. Why is he Hoover? Well, because Vedder and Gallaway have told me that Hoover was the inventor of the high wage policy. What did Clinton run on? Higher real wages. Now, it was Bush who first went to Tokyo with “Jobs, Jobs, Jobs.” That was before he threw up in Miyazawa’s lap. It was Clinton who campaigned along with Reich and others on the need for higher real wages. That sounds a lot like Hoover to me. And if I put it in that context even, it actually has some economic logic, because, after all, Hoover tried to balance the budget by raising taxes. That’s exactly what Clinton is trying to do. He’s trying to balance the budget by raising taxes. So one of the many benefits of my reading this book, and I’ve had it in my hot little brief- case for five or six days, and finally read every page, I dare say. Am I the only person here to do that? Now, come on, be honest. I’ve now been able to link Clinton to Herbert Hoover, which was no mean feat. Thank you very much.

Richard Vedder

This session, as I was originally told, was to address the question, does government cause unemployment? We could save a lot of time and human resources simply by answering the question “yes,” and turning our attention to other things. But, like most things in life, the issue is not appropriately addressed in simple black and white terms, and during this session we would like to draw on some historical experience and some simple economic theory to give our perspective the background needed. Actually, a better answer to the question would be “no, government does not directly cause unemployment. Unemployment occurs when labor gets too expensive.” History shows us however, that government has played a significant role in causing excessively priced labor and thus joblessness. By contrast, the centralized decision-making process is associated with market activity, have done a generally good job in relieving the pressures of unemployment when they developed. The market approach to unemployment elimination, while not perfect, has certainly been clearly superior to the governmental intervention approach in dealing with the topic, at least in this century.

Now, let me make something very clear at the beginning. The superiority of the market process in dealing with unemployment does not arise in our judgement, because the people in the private sector are necessarily superior in some intellectual sense, or moral sense, or any other sense to their public sector counterparts. Lincoln’s notion of government by the people, points out that government decisions are made by fellow human beings. We reject to extreme views of politicians and bureaucrats who run government.

The first view which is popular with those on the left, is a romanticized perspective that implicitly assumes that government decision-makers have extraordinary amounts of two personality traits. First of all, they are unselfish, altruistic human beings. Veritable Mother Theresas who pursue policy-making with a single goal of promoting the common welfare. Secondly, they are extraordinarily wise and bright. Able to see the forest through the trees. Able to overcome the pitfalls associated with looking at only small portions of the economy and polity as do private entrepreneurs.

The second view of government bureaucrats, popular with some on the right, is a demonized perspective that implicitly assumes that government decision-makers are selfish and corrupt on the one hand, and not too bright on the other. According to this perspective, people with ambition and talent seek the higher rewards and challenges of private sector employment, while dullards and incompetents seek the security of government jobs. Moreover, these public sector individuals tend to steal as much as they can from the public purse, despite their lack of intelligence, their ability to do so is high, owing to the lack of accountability of government actions.

Now in our work, we don’t pass judgement on these extreme characterizations. Indeed, I suppose we implicitly assume that instead, the competence and integrity of public employees is probably roughly the same in the public and private sectors. That may be an overly optimistic assessment of our civil service, I don’t know.

Nonetheless, the evidence is clear that the decentralized private sector decision-making, in response to market forces, has generally been markedly better from the standpoint of employment opportunities, than public sector decision making in response to the political process. Why then, does the market mechanism outperform the political process in resolving unemployment? The reason is that the market is simply a better institutional arrangement to make resource allocation decisions than government. The market provides information that is superior qualitatively and quantitatively, and is delivered more expeditiously than the information delivered by the political process. Moreover, the market provides powerful incentives to private sector managers to behave in a manner that tends to minimize unemployment, whereas those incentives are weaker in the public sector.

Now our reading of the unemployment experience of the twentieth century does not say that markets are perfect. From time to time, signals sent by the markets are incorrect, or more likely I think it should be said, they are misread by the decision-makers within the private sector. Occasionally participants in the market over-react or under-react to market information. Some market discordination occurs. A by-product of which is a rise in unemployment. Even with markets, the cost of providing and receiving labor market information is not zero. And these costs prevent instantaneous elimination of surplus workers by the forces of supply and demand. Yet, to paraphrase Winston Churchill, “The market is the worst means of eliminating excessive unemployment, except all the others.” The Soviet Union claimed to have no unemployment, but people overthrew that wretched economic system, and the so-called zero unemployment, centrally-planned, command economies are in retreat everywhere. Except where they are maintained by brute force.Having recently been in Southern China, I’ve noted that the people are hustling and bustling with smiles on their faces as market forces increasingly replace government- imposed resource allocation. People are more prosperous, but even more fundamentally they have more choices, less drabness, more opportunities and hope for success in their lives.

The U.S. has been the governmental approach to eliminate unemployment, tax, spending and monetary policies of the Keynesian approach. The historical evidences that such efforts have often proven very ineffective. Indeed, in some cases worsening rather than reducing cyclical instability.

So after briefly reviewing the economics of unemployment, it’s to that historical evidence that I want to turn for a few minutes, as does my colleague Professor Gallaway.

Throughout history there have been two major competing theories or explanations of unemployment. The first is the one that we stressed here today, often called the classical or sometimes the neo-classical perspective. A majority of economists believed this approach before 1930, I think, although often with very little conviction, since unemployment was a topic that was little discussed. The neo-classical approach also accepted by economists of the Austrian school, holds that unemployment results when the price of labor becomes too high. At excessively high prices, the quantity of labor supplied exceeds the quantity demanded, so unemployment exists. More simply, unemployment results from excessive wages.

Now, this perspective suggests that the elimination of unemployment can come about by reduction in the level of money wages, narrowing the gap between the quantity of labor supplied and demanded. But also, the demand for labor itself can increase in two ways. First, if the productivity of workers rises, the income received from each workers output rises, what we in economics technically call the marginal revenue product of labor. This enhances employer incentives to hire workers at any given wage or price, similarly, if increasing prices themselves raise the nominal value of the output produced by workers, the marginal revenue product also rises, also increasing labor demand.

Finally, unemployment can be reduced if there are sudden reductions in the supply of labor—a theoretical possibility that has been seldom realized in the real world. Ignoring the supply shift possibility, unemployment can be eliminated by a reduction in money wages, or by increases in prices or productivity. We might also say that unemployment rises with increases in the adjusted real wage, which is money wages corrected for changing prices, and also adjusted for productivity change. If the real costs of labor per unit of output rise, the adjusted real wages rise, and with that unemployment. Another way of putting it, if labor costs, as a percentage of sales go up, the upward pressure on the adjusted real wage will lead to higher unemployment. Still another way of putting it, or saying the same thing is that when labor share of the national income increases, unemployment will rise.

Now the second major perspective on the determinants of unemployment, might be called the underspending or underconsumption approach. Although this view is associated today with John Maynard Keynes, it was espoused by several prominent economists long before Keynes’ magnum opus, published in the 1930s. The underspending approach dominated economic thinking from the 1930s to the 1970s, and remained probably the leading approach to eliminating unemployment of espoused by economists even today, although I agree with Bob that it’s much more in debate today.

The Keynesian or demand side approach argues that unemployment results from insufficient total or aggregate demand for goods or services. If we can increase that demand then employers will hire more workers. That demand is increased by various government policies, so it was argued by Keynes most traditionally by running budget deficits, by increasing government spending and/or reducing taxes. The Keynesian argued that the classical or the market approach does not work because the wage and price mechanisms that should respond to the existence of unemployment simply do not work sufficiently or with enough speed.

Now, Professor Gallaway is a labor economist. I am an economic historian. With these combined professional interests, we felt we could offer an interesting evaluation of the two competing theories using historical experience. And our research on this topic goes back for over a decade, and with the help of David Theroux, we finally managed to complete our historical interpretation of the American unemployment experience a few months ago in the book, Out of Work.

There were three times in this century in which the unemployment rate has unambiguously risen above 10 percent. In 1920-22, in the 1930s, and in 1981–82. Let’s talk about those three episodes.

Turning to the first one. After the boom associated with World War I, (it ended in 1920) unemployment rose sharply, averaging nearly twelve percent in 1921. Yet that depression, as it was called, ended quickly. Unemployment fell below its long term natural or long term average rate, or natural rate by 1923. Why did this so called depression begin? And why were we so successful in ending it? The ’20–’21 depression arose in large part because a wild, unprecedented movements in wages and prices led to labor market discordination. A substantial inflation during World War I and shortly after, abruptly turned to deflation, temporarily pushing the purchasing power of wages up and making labor unaffordable. But why did the inflation occur in the first place? In the middle of 1914, the Federal Reserve system began operation. And by 1920, just six years later, the money supply, using M2 definition of money had more than doubled, (an annual average increase in the money supply of over 12 percent a year. Yet in 1921, the money supply actually fell. You are growing 12 percent a year and then all of a sudden you fall. The money supply. And while there was a very strong international dimension to this episode, it does appear that the Feds failed in its mission to stabilize the value of the medium of exchange. Well after a year or so of rising real wages, money wages began falling more than prices, driving down real wages and setting the stages for recovery. The market process worked, the unemployed went back to work and the depression ended almost as fast as it began. The unemployment rate fell by 43 percent in the year 1922 from what it was in ’21, for example.

Now what role did government play in the recovery? With regards to monetary policy, it was restrictive. The money supply M2 was lower in 1922 than it had been at the business cycle peak at the beginning of 1920. M2 grew less than 3 percent in the critical year 1922, after having fallen in ’21.

What about fiscal policy? Woodrow Wilson was temperamentally an activist, but he was a very sick man in 1920. He had a stroke. The new president who came in at the middle of the down turn of Warren Harding was philosophically opposed to intervention. Government spending fell 35 percent in fiscal year 1922 from a year earlier. The government ran a budget surplus in 1921, and a bigger one in 1922. In short, the invisible hand of market forces ended the depression, despite the persistence of monetary and fiscal policy, that from a Keynesian perspective were perversely contractionary. Then came the big one, the 1929 downturn. We are skipping over a little history here. Read the book if you want the full details. In an hour we can’t do a whole book. The 1929 downturn has been portrayed as traumatic depression, beginning with a stock market crash in October. Certainly the great crash in October contributed to the severe recession in a very short time. But the statistics tell us that the 1929 downturn for well over a year was milder than that of 1920-21. Industrial production fell less, the 1930 unemployment rate was well below that of 1921. Yet the market mechanism got us out of that more severe ’21 downturn. But nothing seemed to get us out of the abyss that led to ten consecutive years of double digit unemployment. What happened? What was the difference? The problem was not market failure, but government failure.

While the policy sins of Washington were many, the fundamental problem was a high wage policy enunciated by Herbert Hoover. He called in the nation’s business leaders to the White House in November, less than a month after the great crash. He said the solution to the emerging downturn was an increased spending. Hoover was a proto Keynesian, an under consumptionist. He saw the way to prosperity was to maintain wage rates, rather than allowing them to fall as they normally would in depression. Business not only listened, they obeyed Hoover. Now you might say, why? Today, most business leaders don’t pay much attention to the politicians. They do so only if they are forced to by law. What was different then? Well, in 1929 Herbert Hoover was enormously respected. He had just been elected president a year earlier in a land slide. He was an extraordinary successful business man, a millionaire in an age where wealth was venerated. He was an engineer in an era where people thought science and engineering held solutions to the worlds problems. America’s leading business men believed Hoover. The legendary Henry Ford came out of this White House conference saying that he not only pledged to maintain wages, but he was going to raise them. Go one step further than Hoover. If high wages were good, let’s make them higher. And he actually raised wages. He almost went broke within two years, but he did.

Now our analysis shows that Hoover got the results that he wanted. Wages in 1930 are estimated to have been 8 percent higher than economic conditions warranted, or what they would have been normally in a situation such as that. Rather than creating jobs, the high wage policy destroyed them. Workers were priced out of the market. Worse, the labor market extortions led to a tragic debacle in financial markets. That aggravated the downturn. And how did that come about? The high wage policy caused companies to have dramatic deterioration in their balance sheets very quickly in 1930. As a consequence, some bank loans to companies became very risky. And bank assets declined in value, wiping out the true market value of bank capital. Depositors concerned about this, began converting deposits to currency. Starting the run on banks that led to a decline in the money supply.

As Milton Friedman and Anna Schwartz have so competently and brilliantly demonstrated, the Federal reserve completely failed in its job of currency stabilization. As prices fell, real wages tended to rise, aggravating the unemployment problem in 1931 and 1932.

There were some other little problems. The Smoot-Hawley tariff didn’t help. A huge income tax hike in 1932 is another example of policy sin.

Now, it’s our thesis that Roosevelt and Herbert Hoover were much alike. Both were wealthy, interventionists who believed that the key to economic recovery was increasing purchasing power. Both believed in maintaining or increasing wage rates. Both had little faith in market forces. Roosevelt continued the high wage policy of Hoover’s. Unemployment, which had peaked at about 28 percent, in our estimation in March of 1933 began to fall about one percentage point a month, for several months after Roosevelt took office, suggesting that a moderate strong recovery was under way. In other words, Roosevelt had a positive effect on the economy shortly after he took office. In late ’33, the recovery stalled. Unemployment remained about 20 percent for over two years. Why? The National Industrial Recovery Act approved in June of 1933, had minimum wage provisions that employers had to adhere to if they wanted to get the benefits of participating in the NIRA program. The effect of all this was to raise factory wages by an astonishing 22 percent in six months, at a time of over 20 percent unemployment.

The market forces beginning to bring about recovery were thwarted again. In 1935, the NIRA was declared unconstitutional. And, for about two years, falling adjusted real wages contributed to a very vigorous recovery, with the unemployment rate falling in our estimations to about 13 percent in early 1937. That was less than half it was when FDR took office. Again however, as we begin to see the light at the end of the tunnel, the government added more tunnel. In this case, the villain was the National Labor Relations Act, or Wagner Act of 1935.

Now there was a delayed impact taking effect, part of an issue related to his constitutionality, by 1937, it had the delayed impact leading to the unionization of millions of workers in major industries, which is autos and steel. Causing money wages to rise 13 percent in six months, reversing the recovery previously observed. Now from late ’38 onward, new deal wage shocks were very minor in nature, in spite of the fair labor standards act, which didn’t have much impact right away. Allowing the market to finally work, unemployment fell into the single digits well before Pearl Harbor. The notion that World War II got us out of the depression, is certainly flawed, as my distinguished economic historian colleague Bob Higgs will tell you tomorrow at great length. I’m not sure how great, but substantial.

The greatest misinterpretation of economic history in the twentieth century in my opinion though, occurred in the immediate post-war period. The standard interpretation today is that pent up consumer and business demand for goods kept the nation from falling back into a depression after World War II. The evidence is crystal clear that that interpretation is faulty. Keynesian economists all predicted double digit unemployment as the government engaged in the most extraordinary, contractionary fiscal policy, and a tightening of the monetary belt as well. But instead of depression, the unemployment rate rose to a level of about 4 percent, which was even below the normal, or natural rate of unemployment. Market forces worked magnificently after World War II. With the adjusted real wage declining, which along with some withdrawal from the labor force by female workers brought about a remarkable transition. It was the market’s finest hour. Yet the Keynesians managed to impose an ad hock ex post interpretation that said it was a demand side recovery, even though the economy had transformed itself to civilian production long before the major durable goods industry could get into high gear.

Now I’ve talked long enough. We’re halfway through the story. For the second half, I turn to my colleague, Professor Gallaway.

Lowell E. Gallaway

I want to pick up on some comments that Larry Kudlow made and say a little bit about our model in terms of its being either a redistribution model, or a growth model. One interpretation, and this is where the negative political fallout can come from an adjusted real wage model, is that we are talking about a redistribution approach to dealing with the unemployment rate. Namely, that we are going to approach the world as if it is a zero sum gain, and the way we can get unemployment down is by redistributing income from employers to employees. I suspect to be perfectly honest that there is very substantial element of that redistributionists philosophy in some of the current Clinton proposals. That gives you sort of a negative pass of things in a way. You are just doing the usual thing that economists are accused of doing—raining on everyones parade. You know, “you can’t have this, unless you can have that.”

Well, that’s not the only side of the story. The other side of the story, as Larry correctly pointed out, is to put this in the context of a growth model. The important thing is not the level of the adjusted real wage, it’s its relationship to the equilibrium adjusted real wage. The important thing for many people, though, is the level of the real wage rate that goes with it. And the only way in the long run that you get that wage rate up, is through enhancements to productivity. That’s been the story in the United States going back with a date of sources, as far back as I can get is 1840. And that has been a very serious problem in recent years with the American economy. Various measures, no matter how you measure real wages, real compensation, it’s clear that the rate of growth has slowed dramatically over the last 20 years. And I would suggest that a good bit of that can be attributable, can be traced to a variety of government policies. Perhaps the most pernicious piece of legislation of all was the budget reform act of 1974, which reallocated political power in Washington to Congress that has a remarkable propensity to spent. And those are the problems that Rich was eluding to in his remarks.

The long run question, if you are going to have an optimistic view at all, you know, if I have any hopes for my grandchildren you know, and the like, the long run view you are going to have to take is that you’ve got to do something on the productivity side. And I don’t mean some Mickey Mouse approaches to productivity, we’re going to have learning taxes and all of that. Government very simply has to get out of the way and let the entrepreneurial spirit of the American economy work. Steve Moore was asking the question, “why do we only have 7 percent unemployment?” “Why don’t we have 10 percent unemployment” It is really very simple. It is very straight forward. The market place as exemplified by labor markets, has a remarkable capacity to get good performance, or at least relatively good performance out of bad intentions. There are limits, though to what the market place can do. I am a free market type, but I would never tell you that markets are always going to give you the best of all possible worlds. All markets do, is process information and access costs. And they access costs and burdens in a very relentless fashion, and if we don’t get out of the way and let that entrepreneurial spirit work, and get the innovations that will give us rising levels of productivity. As we load more burdens on the market, those burdens are going to be accessed and they are going to reflected in the labor market in one of two ways.

Either real wages will come down, as these governmental costs are added or unemployment will go up. The only way you get out of the box is to foster greater growth and productivity.

Stephen Moore

Thank you, I am on leave from the Cato Institute and as some you may know, I am working for Dick Armey, so I think my challenge today is to the speech that Dick Armey didn’t give last night.

The topic of this panel is the future of government and unemployment, and the best thing that the government can do to reduce unemployment is for us to elect Dick Armey President in 1996.

Now we have a president today, and Rich and Lowell may be able to correct me on this, but I think among professional economists, Bill Clinton is probably the most popular president ever elected. Back during the campaign, over 200 of the most eminent economists in the country signed a statement supporting the basic tenants of Clintonomics. This included Paul Samuelson, Robert Solo, Hal Broner, virtually the entire economics faculty at Stanford, MIT, Northwestern, The Brookings Institute. This is something that we should be very worried about in my opinion. The fact that so many of these people who Lowell and Rich show so convincingly they have been wrong over the last 50 years are now so enthusiastic about the policies of Bill Clinton.

Now, Arthur Schleshinger has a theory that we go through cycles, political cycles in this country about every thirty years, and I think that that’s true and that we are in a new cycle right now with the Presidency with Bill Clinton, and I think it is very interesting, about every thirty years we have to sort of rediscover liberalism. Because people forget I think. I think people forget how bad things get under liberalism, and I think that is where we are right now, in a cycle where people after the high growth 1980s people became very contented with things and now we are having a new economic experiment. So the consequence of that is that we have a president who goes around bashing America’s premier growth industries for example, the pharmaceutical for shameless profiteering. We have a vice president who thinks that the solution to our economic problems is to ban the combustible engine. We have a chairman of the council of economic advisors who a few months ago before the Joint Economic Committee said that the major problem with the United States is that we are undertaxed. I was struck by that because it didn’t seem quite like it was the populous message of his/her employer. This is the kind of view that we are getting in Washington under the new regime.

Now, when I look at the policies that have taken place over the last five years, and I agree with you Steve, that we did have in George Bush a third rate fireman and you look at the policies that took place, and to me the real mystery is why in the United States we only have 7 percent unemployment. It’s a real testament to the resilience of the marketplace that government has done virtually everything possible over the last five or six years to destroy jobs. And yet we’re still only at 7 percent. What I would like to ask you maybe for discussion is why aren’t we at 10 percent or 12 percent? We certainly seem headed in that direction.

I want to cover five quick key points in my discussion, and these are the following.

First, I think that when I read Lowell and Rich’s book, and look at how unemployment has slowly ratcheted up over time, I would make a case to you that this is almost a direct consequence of just simple, that you can correlate this very closely with government growth and that the relentless rise in government in this century explains much of increase in the slower growth rate and also the increase in unemployment.

The second point that I would like to make this afternoon, is that in the last fifteen years, the Keynesian model has been in my opinion, entirely discredited by events, just as it has been in earlier times, as Lowell and Rich show. But I would make the further point that to some extent, you’re carrying down a straw man, because I don’t think in my opinion that the left is even practicing Keynesian economics anymore. They are not practicing any kind of coherent economics policy. They are simply in my opinion, unfailing believers in the efficacy of big government. And that to tear down one intellectual theory of theirs isn’t going to get us very far, because they will simply move to another one.

The third point that I would make, is that the economic plan that the president has put forward in front of us today is an intellectual fraud.

The fourth point that I would like to make is that the Clinton economic plan will do substantial economic damage to the economy, and it will, as Steve Hanke correctly points out, increase unemployment and reduce growth.

And finally, I’ll just mention a couple of steps that need to be taken to reverse these. Now on the first point, government growth, and how is this responsible for unemployment. Now Rich and Lowell make a point that over the past century, there has been a relentless growth of unemployment, although it waves over time, there has been a gradual increase, and I was struck by the fact that you saw that for instance, at the beginning of the century, it was uncommon to have unemployment rates go over 5 percent, and that unemployment was generally about 4. Well, when we look at the situation today, we feel lucky when unemployment dips below 7 percent. Well let me give you some just basic statistics in terms of what’s happened over the century that I think very carefully explains this.

First let’s just look at an overall government expenditures, and these are in real dollars. In 1900, the government spent per household about $1,650 per household. By 1930, just prior to the new deal, it had doubled to $3,300 per person per household, and again these are in real dollars. By 1960, it had quadrupled to $12,790 per household, and today, in 1992, we are at $24,000 spending per household. Now some of you will say well sure, but the economy is a lot larger now, so let’s look at these statistics as a share of gross national product to control for the growth of the economy.

In 1900, government spent about 9 percent of GDP, which squares exactly with what Lowell and Rich point out, that the government was spending about one less than one of every ten dollars of output. By 1930, that number was up to 12 percent. The big growth was from ’30 to ’60, because by 1960 that number was 27 percent of gross output, and today in 1990, government at all levels takes about 37 percent of gross domestic product. Now, what about where this spending has taken place? Now one of the arguments that the left makes about these numbers is yes, we’re spending a lot of money, but we’re not spending it wisely. We’re not spending it in the right areas that produce human capital, and so forth.

So, I looked at just one area that is supposed to increase human capital, which is education spending. And I just have reliable data back from 1950, but just to give you some of these numbers. In 1950, real spending per person in the public schools was about $1,800 per student. By 1970, that was $3,500 per student, or twice what it was 20 years earlier, and in 1990, it was $6,500 per person, or almost double what it was in 1970. Now the interesting thing about this is that back in the early 1970s when it became clear that there was an emerging failure of our public school system, the left in the teacher’s unions said that the solution to this is to put more money into the public school system, and of course, as my statistics show to you, we have done that with “boatloads” of money, and yet the interesting thing is, that if we did a correlation as most of you are familiar with between spending per person and any kind of measure of output or achievement, we’d find a very strong negative relationship. George Will has a very interesting comment about this. He says that back in the 1970s, when he was on the school board, the school board told him that if all we increase are expenditures on our kids in this school system, we can create a nation of Einsteins and Edisons. And he said by 1990 he felt like after doubling spending on education, we were lucky if our kids knew who Einstein and Edison were. And I think that’s probably representative of the situation in most school districts.

Now let’s look at how we pay for all of this growth of spending through taxation and how that has relentlessly grown. In 1930, taxes took about 12 percent of our gross domestic product. By 1960 that was up to 29 percent and by 1990 over one third, or 34 percent of all goods and services produced were consumed through taxation. Now the very interesting point I think, and a point that Steve Hanke raised, was that if you looked at taxation of labor in this country, this is where the largest increase has been.

Let’s look just for example at Social Security taxes and a vast expansion in Social Security. In 1940 when the program was first introduced, the Social Security payroll tax was one percentage point paid by the employer, and one percentage point paid by the employee, or two percent payroll tax. By 1960, it was 6 percent, by 1980 it was 12 percent and by 1990 after ten years of the Reagan era, it was up to 15 percent. And now, Steve also correctly points out Hillary is talking about somewhere in the neighborhood of a 5 to 10 percentage increase in these taxes on labor. So it should not be a great mystery in my opinion, that we are seeing more unemployment given these rises in Social Security or labor taxes. The one last era I’d like to look at, which is directly related to unemployment, is labor laws. Last week I asked the CRS to document how many labor laws have passed over the last 50 years. These are major labor laws that have passed that affect unemployment. In 1950, they told me there were four labor laws. By 1970, there were 19, by 1980, there were 37. Now this is probably the most interesting thing, that in 1980, right before we had 12 years of Republican administration, we had 37, after 12 years of Republican administration, we had 90 labor laws. So the 1980s was probably the fastest era of growth in labor laws ever. And of course, since they did this study, they went through 1990, we’ve passed just a few months ago, the Parental Leave bill. Striker replacement is coming up next this fall, and I think it stands a fairly good chance of passage. They passed voluntary parental leave last year, I think what they’ll be looking at in 1994 is a paid parental leave, where the employer actually pays the employee while he’s on parental leave, (he or she.) Also, I believe that they will by looking very seriously at requiring large employers to provide a child care for workers. Those are things I believe are coming down the pipe.

Now, when you look over the last ten years, the great failure of the Reagan years, and there were great triumphs, no question, is that when you look at the Reagan/Bush era the last 12 years, what you find is that aside from the fact that we had a large tax cut in 1981, thanks to people like Larry Kudlow, after 1981 you guys didn’t do that much that was very good in terms of helping the economy. Let’s just look at some of the things that have passed over the last 10 years that have destroyed jobs. In 1982, we had TEFRA. That was the largest tax increase in the history of the country until George Bush was elected. The second, in 1983, we had the Social Security commission which was headed by Alan Greenspan and gave us the large Social Security tax hikes that I mentioned took place in the 1980s. In 1984 we had DEFRA, which was the deficit, I don’t even remember what it stands for, but it was another one on these very successful budget summons that we’ve had over the last ten years. In 1987 we had the mini-summit after the stock market crash, where we raised taxes again. In 1988 another one of the increases in Social Security taxes took place, that had been scheduled from the 1983 Social Security commission. In 1990, we had another one of these increases in the Social Security tax. In 1989 we passed the minimum wage increase. In 1990 we passed the disabilities act. In 1990 we passed probably the largest job destruction bill of the last 15 years, which was the Clean Air Act, and shortly, about a month later, we passed the civil rights act. Now, when you look at all of these acts that we’ve passed over the last 10 years, the question again is why is it that Bill Clinton says that the problem of job creation is vexing? What’s so vexing about this problem of job creation? The government has done nothing to promote job creation, and everything possible to destroy jobs.

Now, let me go on to my second point, which is that the Keynesian model in my opinion has been entirely destroyed by recent events. First, I want to take just a few minutes and talk a little bit about how spectacularly wrong the Keynesian have been over the last 15 years, engaging in how economic events would unfold. By the way, Lowell Gallaway was very helpful to me in doing this project, which I completed several months ago in terms of tracking what Keynesians had said at the time, and then tracking what actual events occurred. Let’s start in 1978 when we were in the midst of a mini-recession at that time, and Jimmy Carter was in office, and the left’s agenda to get rid of this mini-recession that we were in, was to pass a quote “fiscal stimulus bill.” This may sound slightly familiar. The interesting thing about this fiscal stimulus was that it was going to increase the deficit to about 3 percent GDP, which was seen by people on the right as being a problem, but the Keynesians did not see it as a problem at all. For example, one of the problems that the supply siders saw with this fiscal stimulus was that it would be inflationary. But the Keynesians were very quick at telling us this would not be an inflationary policy. Let me give you some examples. Walter Helger who was probably the most revered Keynesian of the time, and was the chairman of John F. Kennedy’s counsel of economic advisors, confidently predicted before the Joint Economic Committee, that the 1978 fiscal stimulus did not quote “even present a remote specter of inflation.” Remember, this is in 1978. At that time the Joint Economic Committee came out in favor of this fiscal stimulus and at that time as irony would have it, Lloyd Benson was the chairman of the Joint Economic Committee. Lloyd Benson said this about the 1978 fiscal stimulus, that “I do not believe this deficit is inflationary, nor will it crowd private borrowers out of credit markets, or reduce private economic activity. It is very interesting how Lloyd Benson doesn’t quite make that argument today as we’re putting forward a contractionary policy right now through a tax increase, his argument is that we have to have this tax increase in slow economic times because deficits are crowding out private investment.

Now, as all of you know, the Keynesians were spectacularly wrong about the inflationary implications of this policy and in fact by the year 1979, the year after this fiscal stimulus took place, inflation rate rose to 13 percent. By January, 1980, the inflation rate was 18 percent.

Now, let’s fast forward to 1980 and 1981. The supply siders, led by people like Larry Kudlow were arguing for something called the Kemp Roth tax bill. And a Kemp Roth tax bill, interestingly enough, is something you would think the Keynesians would be very excited about. It is a policy that reduces taxes, it is a stimulant of fiscal policy, and even if they don’t buy these supply side arguments, they would seem to favor this for demand side implications, and yet the most interesting thing about the Kemp Roth bill, is that virtually every Keynesian in the country came down against it except Robert Eisner. I’ll say this right now, that virtually everything I am saying about Keynesians, Robert Eisner is the only intellectually honest Keynesian in the country. He may be wrong, but he isn’t consistently wrong.

Now, does anybody in this room know what the major attack at the time in 1980 and 1981 was against the Kemp Roth tax bill? They went crazy over the prospects of inflation, and I thought it might be interesting to give you some of points that the Keynesians made about the 1981 tax bill. And by the way, I think that you, Lowell, are the one who gave me some of these quotes but they are just so precious that I have to give you some of those. First, Paul Samuelson, the father of neo-Keynesian said, and I think you mentioned this yesterday- his Newsweek quote where he said in 1980, that he saw two digit price inflation as a distinct possibility for much of the decade of the 1980s. He also said that he thought that the CPA would average about 9.4 percent a year over that period. And he also said that he saw the unemployment rate averaging about 8.5 percent over the period of the 1980s. Interesting prediction. James Stoben had a very similar attack against the Kemp-Roth tax increase. He said there’s a better a surer way to attack stagflation than Reaganomics. It is to organize a consorted mutual disinflation of wages.

Samuelson later said that he thought that five to ten years of austerity in which the unemployment rate rises toward an 8 or 9 percent average, and real output inches upward at barely 1 or 2 percent per year might accomplish a gradual taming of U.S. inflation.

Now let’s go on specifically to some of the things they said about Kemp Roth. Those were the predictions they made. Walter Heller said that he thought a 114 billion dollar tax cut over 30 years would simply overwhelm out existing productive capacity with a tidal wave of demand and sweep away all hope of curbing deficits and containing inflation. Now this is the same man who said three years later that he saw no specter of inflation from the demand-side policies of Jimmy Carter.

Finally let me give you a quote from Hobart who was the major Keynesian journalist of the country and writes for the Washington Post, who said that he thought that Kemp Roth was “dangerously inflationary” even if Congress were to pass budget cuts that match the tax cuts dollar for dollar, there’s nothing in the fiscal program in the views of those who are not addicted to the supply side theory that works against inflation, and on and on and on. Now the interesting thing here of course is how wrong they were about the Kemp Roth tax cut because in fact we did pass the tax cut, and inflation went from about 12 percent in 1980 down to about 4 percent as an average over the Reagan years.

Now, let’s fast forward to the period after the Reagan tax cuts to the period of prosperity, the period between 1983 or so to 1989. What you have duing this period is a steady drumbeat from the left, from the Keynesians for a tax increase. And you were on the hill sometime during this period, both of you. I can’t remember a single joint economic committee hearing where we didn’t have one of these Nobel laureates come up and say that we need to have a tax increase to deal with the deficit, over and over and over again. So for example when we had the stock market crash in 1987, there was a great rejoicing of the left, and all of the Keynesians ran to the hill to say how this was proof that we had bred an arediced in terms of passing a tax increase. Now the important point here is, at the same time, there was universal scorn for Reagan budget cuts. That is none of these Keynesians who had turned into deficitphobiacs had ever said that they thought that we should cut the budget. They all said that we had to raise taxes. But in fact they called Reagan’s budget cuts unfair, they called them Draconian and so forth and so on.

Now some people say that the period of growth over the 1980s—the period between 1982 and 1989 are what Bob Bartley calls “The Seven Fat Years” were essentially a Keynesian experiment, that we had large deficits and we had large growth, and of course, isn’t this what we’d say Keynesians would expect?

Now, you could argue that case, but I’m going to argue the opposite by saying that from a period 1985 to 1989, we had a huge fiscal contraction. In fact the budget deficit went down from about $230 billion in 1985 down to less than $150 billion in 1989. Now that doesn’t seem like a huge increase in the deficit in terms of dollars, but when you consider that the economy was growing rapidly during this period. When you look at the deficit with a percent of GDP, what you find in fact is that the deficit was reduced from about 6 percent of GDP to 3 percent. That is not a Keynesian fiscal expansion. And yet over this period of ’85 to ’89, we created 6 million jobs and the economy surged forward. Now, contrast that then with the period of 1990 to 1993. Now, my question is, if the Reagan period was a great Keynesian experiment that created all this growth, then after four years of George Bush, we should have all been driving around in limousines. Because, the fact of the matter is, the George Bush’s era, or what I would call the Bush/Dommer era, was one of the largest experiments in fiscal stimulus ever. The budget deficit climbed from 150 billion over this period, to about 300 billion by 1993. This was a huge growth in the deficit. Now, the question is, and moreover, all of the kinds of programs that the left says that promote growth and so forth, all of those programs we significantly funded. Let me give you some examples of how we spent money in the period 1989 and 1993. And I’m looking at the programs that the left would consider “investment programs,” the kinds of programs that create jobs and growth.

During the Bush years, spending on child programs grew by 67 percent, including things like Head Start and so forth. Education and training spending grew by 16 percent. By the way, these are all in real adjusted for inflation dollars. Federal aid to states and cities grew by a real 55 percent from 1989 to 1993. Infrastructure spending grew by 32 percent in real terms. Nutrition programs like Wick and so forth grew by 72 percent, and research and development funding grew by 20 percent. Now again, in addition to the large fiscal stimulus that we had, we had a lot of money poured into the programs that are supposed to be most stimulatory.

Now let me fast forward to the Clinton era, what Bill Clinton has proposed, and his plan. Now I will start by simply saying that in my opinion, this plan will not cut spending, it will cut the deficit and will not promote jobs and economic growth. What we have in my opinion, is an exact duplication of the 1990 budget deal. Even down to the wording and so forth that the left uses to defend this. For example, if you look at the major elements of this, we have rate increases on the rich. Of course we had that in 1990. We have a gasoline tax increase, we had that in 1990. We have $500 billion of savings which we had in 1990. We have tax hikes that are front loaded and spending cuts that are supposed to come later just as we had in 1990. The interesting thing about the 1990 budget deal, is the more that our side makes the case that these two things are similar, the more often we see the left arguing that in fact, the 1990 budget deal worked after all. In fact, the fact that the deficit virtually doubled over this period and so forth, doesn’t matter because growth was slower than we expected. Now can you imagine that, we had a large tax increase in 1990 and we had slower growth. I don’t think that people like Leon Panneta see any relationship between those two things.

Let me give you very quickly the key details of what Bill Clinton is proposed, because I think you’ll be very interested in some of these numbers that don’t make it into the popular press.

Key detail number one, 70 percent of the spending cuts in this program occur in 1997 and 1998. Now with any luck, Bill Clinton won’t even be president in 1997 and 1998. And it’s very doubtful that whoever succeeds him is going to want to stick to this budget deal.

Key detail number two, spending that is overall government spending will rise by $300 billion if everything goes right under this program over the next five years. This is a budget increase program, it does not cut spending.

Third, the ratio of taxes to spending cuts is not 1 to 1, it’s not 2 to 1, it’s not 5 to 1, it’s the infinite number to 1, because the fact of the matter is, there are no spending cuts in this proposal. You can’t have $300 billion of spending increases over the next 5 years, and say that you are cutting spending.

Fourth, $90 billion of tax increases take place in this program, before we get even a single dollar of these fictitious spending cuts that Bill Clinton is taking credit for. That is in the first year and a half of this program, there’s not a single dollar of spending cuts. Now anyone, and I think Larry will back me up on this, anyone who’s ever had any experience with these budget deals notice that the useful life of them is no more than 18 months. So for the first 18 months, we get $90 billion spending cuts, then when the useful life of the program is over, then we get all of these supposed spending cuts.

Key point number five is, and I believe that almost all of the evidence backs me up on this, that the income tax hikes that are proposed in this program, will raise virtually no money at all. It is interesting how even a friend, Martin Felstein is a supply sider, and he’s made a very compelling case I think on the pages of The Wall Street Journal, that in fact if you look at these tax increases, they will raise no revenue. If you need any evidence of that, just look at the experience from the 1990 deal, where in fact we raised tax increases on the rich and the most recent evidence shows two things, one is that the tax payments of those people making over $250,000 actually fell in 1991 according to the data just released, and second of all, the overall percentage of taxes paid by the rich fell after we raised taxes, I think you’ll see an exact duplication of that result.

Key point number 5 is that entitlements are not constrained at all under this program, in fact they are lucent. For example, we create a number of new entitlements under this budget deal. For example, we have free immunizations, Medicaid for illegal immigrants. A huge expansion in food stamps, a huge increase in earned income tax credit, a huge increase in health care benefits for new mothers, and so forth, and so the question is why would anyone think that we would be constraining entitlements when the right hand of the government is creating substantial new entitlements under this act.

The final point that I would make on this plan, is that the cap on health care that is always being talked about is totally fraudulent, and the fact of the matter is that all of these caps are on compensation to medical care providers and so forth. None of them cut benefits. And the fact is that capping compensation and so forth is total voodoo economics, it never works.

Now we ran a dynamic estimate on this program at the Joint Economic Committee to find out what impact this plan will have on jobs and growth, and I’ll simply conclude with some of the numbers that we came up with. We conclude that by 1997, if you look at a dynamic model, this program will create 800,000 fewer jobs by 1997. And also the unemployment rate will be about .7 percentage points higher than it would be if we did not pass this plan. And finally we find that the growth rate will be about .6 percentage points lower than it would be without this plan. Now the final point that you should all realize, is that this doesn’t even include the health care taxes, that is, if you include the health care plan that we think is coming down the road that’s been hidden very skillfully until now, we think that’s like doubling the impact of just this budget plan.

So, let me simply conclude by saying, that government is doing virtually everything it can to destroy jobs, just as Steve Hanke correctly pointed out, and that the mystery is, why are we still able to create as many jobs as we have been? I think what we’re looking for in the immediate future is a gradual reduction in the number and pace of creation of jobs and a period of stagnation. Thank you.

Steve Hanke

Let me comment on Kudlow. Actually, I just want to add something. Larry reminded me of some work that I had done on the model in terms of forecasting and the idea was that, as Warren Burks dubbed the supply sights spread was ultimately the number that we wanted to come up with, so we have a proxy for output in the model. We take the GDP deflator, add productivity to that, that gives us a proxy for output, and then we subtract from a proxy for all of our input costs and labor costs, and that gives us supply side spread. So when the spread gets wide, that’s Kudlow’s profits. Things should be booming. You should be adding capital, you should be adding labor. You want to get out there and produce more because the supply side spread widens out.

Now, I have had some graduate students do some work on this, and what you end up with, with a supply side spread, is that it never gives you any bad signals. When the supply side spread is wide, the economy is going. The only problem with the model is, it has a tendency to be more a coincident indicator than a leading indicator. So in that sense, you can’t foresee what’s going to happen too well, but you are never going to be off track. If you’ve got some worry about what’s going on, you can really look at these spread numbers and they are very good. Now what is concerning to me, I share a short run optimistic view just like you two do, because we’re basically looking at the same thing. However, if you do look at the supply side spread numbers, they started falling. Usually as you come out of a recession, these things really keep going up, right to the end and then start turning down. My supply side spread calculations started turning down in the fourth quarter of ’92 and certainly in the first quarter of this year, they really did turn down. They are still positive, there is still a lot of juice in the system, but this turning around business does have me concerned, and I think that it is leading us into other problems. We’ve got it in the system, I think already.

Lawrence Kudlow

“Not if there is a burst of unanticipated inflation.”

Yeah, the burst of unanticipated inflation, you see how that works into the supply side spread model. You’ve got GDP deflator plus, productivity, minus labor costs, so the proxy for the value of output goes up on you, and this unanticipated inflation will widen that supply side spread out, or it will turn it around.