Www.columbia.edu Vickrey William 1996 15 Fatal Fallacies of Financial Fundamentalism

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Vickrey, William. 1996. 15 Fatal Fallacies ofFinancial Fundamentalism

Much of the conventional economic wis-dom prevailing in nancial circles, largelysubscribed to as a basis for governmental

policy, and widely accepted by the media and the

public, is based on incomplete analysis, contrafac-tual assumptions, and false analogy. For instance,encouragement to saving is advocated without at-tention to the fact that for most people encouragingsaving is equivalent to discouraging consumptionand reducing market demand, and a purchase bya consumer or a government is also income to ven-dors and suppliers, and government debt is also anasset. Equally fallacious are implications that whatis possible or desirable for individuals one at a timewill be equally possible or desirable for all who

might wish to do so or for the economy as a whole.

And often analysis seems to be based on the assump-tion that future economic output is almost entirelydetermined by inexorable economic forces inde-pendently of government policy so that devotingmore resources to one use inevitably detracts fromavailability for another. This might be justiable inan economy at chock-full employment, or it mightbe validated in a sense by postulating that the Fe-deral Reserve Board will pursue and succeed in apolicy of holding unemployment strictly to a xednon-ination-accelerating or natural rate. Butunder current conditions such success is neitherlikely nor desirable.

Some of the fallacies that result from such modes ofthought are as follows. Taken together their accep-tance is leading to policies that at best are keeping usin the economic doldrums with overall unemploy-ment rates stuck in the 5 to 6 percent range. This isbad enough merely in terms of the loss of 10 to 15percent of our potential production, even if shared

equitably, but when it translates into unemploy-ment of 10, 20, and 40 percent among disadvantagedgroups, the further damages in terms of poverty,family breakup, school truancy and dropout, illegi-

timacy, drug use, and crime become serious indeed.And should the implied policies be fully carried outin terms of a balanced budget, we could well bein for a serious depression.

Decits are considered to represent sinful proigatespending at the expense of future generations whowill be left with a smaller endowment of investedcapital. This fallacy seems to stem from a false ana-logy to borrowing by individuals.

Current reality is almost the exact opposite. Decitsadd to the net disposable income of individuals,to the extent that government disbursements thatconstitute income to recipients exceed that abstrac-ted from disposable income in taxes, fees, and othercharges. This added purchasing power, when spent,provides markets for private production, inducingproducers to invest in additional plant capacity,which will form part of the real heritage left to thefuture. This is in addition to whatever public in-vestment takes place in infrastructure, education,research, and the like. Larger decits, sucientto recycle savings out of a growing gross domesticproduct (GDP) in excess of what can be recycled byprot-seeking private investment, are not an eco-nomic sin but an economic necessity. Decits inexcess of a gap growing as a result of the maximumfeasible growth in real output might indeed causeproblems, but we are nowhere near that level.

Even the analogy itself is faulty. If General Motors,AT&T, and individual households had been requiredto balance their budgets in the manner being ap-

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Vickrey, William. 1996. 15 Fatal Fallacies of Financial Fundamentalism

plied to the Federal government, there would be nocorporate bonds, no mortgages, no bank loans, andmany fewer automobiles, telephones, and houses.

Urging or providing incentives for individuals totry to save more is said to stimulate investment andeconomic growth. This seems to derive from an as-sumption of an unchanged aggregate output so thatwhat is not used for consumption will necessarily

and automatically be devoted to capital formation.

Again, actually the exact reverse is true. In a moneyeconomy, for most individuals a decision to try tosave more means a decision to spend less; less spen-ding by a saver means less income and less savingfor the vendors and producers, and aggregate savingis not increased, but diminished as vendors in turnreduce their purchases, national income is reducedand with it national saving. A given individual mayindeed succeed in increasing his own saving, but

only at the expense of reducing the income andsaving of others by even more.

Where the saving consists of reduced spending onnonstorable services, such as a haircut, the effect onthe vendors income and saving is immediate andobvious. Where a storable commodity is involved,there may be an immediate temporary investmentin inventory, but this will soon disappear as thevendor cuts back on orders from his suppliers toreturn the inventory to a normal level, eventuallyleading to a cutback of production, employment,and income.

Saving does not create loanable funds out of thinair. There is no presumption that the additional bankbalance of the saver will increase the ability of hisbank to extend credit by more than the credit sup-plying ability of the vendors bank will be reduced.If anything, the vendor is more likely to be active inequities markets or to use credit enhanced by thesale to invest in his business, than a saver respondingto inducements such as IRAs, exemption or deferral

of taxes on pension fund accruals, and the like, sothat the net effect of the saving inducement is to re-duce the overall extension of bank loans. Attemptedsaving, with corresponding reduction in spending,does nothing to enhance the willingness of banksand other lenders to nance adequately promisinginvestment projects. With unemployed resourcesavailable, saving is neither a prerequisite nor a sti-mulus to, but a consequence of capital formation, as

the income generated by capital formation providesa source of additional savings.

Government borrowing is supposed to crowd outprivate investment.

The current reality is that on the contrary, the ex-penditure of the borrowed funds (unlike the expen-diture of tax revenues) will generate added dispo-sable income, enhance the demand for the productsof private industry, and make private investment

more protable. As long as there are plenty of idleresources lying around, and monetary authoritiesbehave sensibly, (instead of trying to counter thesupposedly inationary effect of the decit) thosewith a prospect for protable investment can beenabled to obtain nancing. Under these circums-tances, each additional dollar of decit will in themedium long run induce two or more additionaldollars of private investment. The capital createdis an increment to someones wealth and ipso factosomeones saving. Supply creates its own demandfails as soon as some of the income generated by thesupply is saved, but investment does create its ownsaving, and more. Any crowding out that may occuris the result, not of underlying economic reality, butof inappropriate restrictive reactions on the partof a monetary authority in response to the decit.

Ination is called the cruelest tax. The perceptionseems to be that if only prices would stop rising,ones income would go further, disregarding theconsequences for income.

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Current reality: The tax element in anticipated ina-tion in terms of gain to the government and loss tothe holders of currency and government securities,is limited to the reduction in the value in real termsof non-interest-bearing currency, (equivalent to theincrease in the interest rate saving on the no-inte-rest loan, as compared to what it would have beenwith no ination), plus the gain from the incrementof ination over what was anticipated at the time

the interest rate on the outstanding debt was esta-blished. On the other hand, a reduction in the rateof ination below that previously anticipated wouldresult in a windfall subsidy to holders of long-termgovernment debt and a corresponding increase inthe real impact of the debt on the sc.

In previous regimes where regulations forbadethe crediting of interest on demand deposits, theseigniorage prot on these balances, reecting theloss to depositors in purchasing power, that would

be enhanced by ination would accrue to banks,with competition inducing some pass-through tocustomers in terms of uncharged-for services. In aneconomy where most transactions are in terms ofcredit card and bank accounts with respect to whichinterest may be charged or credited, the burdenwill be trivial for most individuals, limited to lossof interest on currency outstanding. Most of thegain to the government will be derived from thoseusing large quantities of currency for tax evasionor the carrying on of illicit activity. plus burdenson those few who keep cash under the mattress ofin cookie jars.

The main diculty with ination, indeed, is not withthe effects of ination itself, but the unemploymentproduced by inappropriate attempts to control theination. Actually, unanticipated acceleration ofination can reduce the real decit relative to thenominal decit by reducing the real value of theoutstanding long-term debt. If a policy of limiting thenominal budget decit is persisted in, this is likelyto result in continued excessive unemployment due

to reduction in effective demand. The answer is notto decrease the nominal decit to check ination byincreased unemployment, but rather to increase thenominal decit to maintain the real decit, control-ling ination, if necessary, by direct means that donot involve increased unemployment.

A chronic trend towards ination is a reectionof living beyond our means. Alfred Kahn, quoted

in Cornell 93, summer issue.

Reality: The only time we could be said to have beenreally living beyond our means was in war-timewhen capital was being destroyed and undermain-tained. We have not lived even up to our means inpeace-time since 1926, when it is now estimated thatunemployment according to todays denition wentdown to around 1.5%. This level has not been ap-proached since, except at the height of World War II.

Ination occurs when sellers raise prices; they cando this protably when the forces of competitionare weakened by the differentiation of products,real and factitious, misleading advertising, obfus-cating sales gimmicks and package deals, mergersand takeovers, and the increasing importance ofancillary services, trade secrets, patents, copyrights,economies of scale, overheads, and start-up costs.Ination can and does occur in the midst of unde-rutilized resources, and need not occur even if wewere to consume our capital by failure to maintainand replace it, consuming more than we produce.

It is thought necessary to keep unemployment ata non-ination-accelerating level (NIARU) inthe range of 4% to 6% if ination is to be kept fromincreasing unacceptably.

Currently the unemployment rate as ocially mea-sured has fallen to 5.1%, while the CongressionalBudget Oce (CBO) has put the NIARU for 1964 at6.0 percent, having ranged between 5.5 and 6.3 since1958. Recent CBO protections were for unemploy-

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ment to remain steady at 6.0 percent through theyear 2005, with ination in the urban consumerprice index fairly steady at about 3.0 percent (Econo-mic and Budget Outlook, May 1996, pp xv, xvi, 2, 3).

This may be a fairly optimistic forecast of the re -sults to be expected from current tendencies, butas a goal it is simply intolerable. While even vepercent unemployment might be barely accep-

table if it meant a compulsory extra two weeks ofunpaid furlough annually for everyone, it is totallyunacceptable when it means 10%, 20% and 40%unemployment among disadvantaged groups, withserious consequences for poverty, homelessness,family breakups, drug addiction and crime. Themalaise that pervades our cities may be attributablein no small measure to the fact that for the rsttime in our history, an entire generation and morehas grown up without experiencing reasonablyfull employment, even briey. In contrast, while

most other industrialized countries are currentlyexperiencing higher rates of unemployment thanthe U.S., they have nearly all had relatively recentperiods of close to full employment. Unemploymentinsurance and other welfare programs have alsobeen much more generous so that the sociologicalimpacts have been much less demoralizing.

The underlying assumption that there is an exoge-nous NIARU imposing an unavoidable constrainton macroeconomic possibilities is open to seriousquestion on both historical and analytical grounds.Historically, the U.S. enjoyed an unemploymentrate of 1.8% for 1926 as a whole with the price le-vel falling, if anything. West Germany enjoyed anunemployment rate of around 0.6% over the severalyears around 1960, and most developed countrieshave enjoyed episodes of unemployment under 2%without serious ination. Thus a NIARU, if it existsat all, must be regarded as highly variable over timeand place. It is not clear that estimates of the NIARUhave not been contaminated by failure to allow fora possible impact of ination on employment as

well as the impact of unemployment on ination. AMarxist interpretation of the insistence on a NIARU

might be as a stalking horse to enlist the fear ofination to justify the maintenance of a reservearmy of the unemployed, allegedly to keep wagesfrom initiating a wage-price spiral. One neverhears of a rent-price spiral, or an interest-pricespiral, though these costs are also to be consideredin the setting of prices. Indeed when the FRB raisesinterest rates in an attempt to ward off ination, theincrease in interest costs to merchants may well

trigger a small price increase.

Analytically, it would be more rational to expect thatthere could be a maximum non ination-accelera-ting rate of reduction of unemployment (NIARRU),such that if an attempt were made to proceed morerapidly by a greater recycling of excess savings intopurchasing power through government decits,prices would start to rise more rapidly than hadbeen generally anticipated. This would occur as aresult of a failure of supply to keep up with the in-

creased demand, giving rise to shortages and thedissipation of part of the increased demand intomore rapidly rising prices. This NIARRU may bedetermined by limits to the rates at which laborcan be hired and put to work to meet anticipatedincreases in demand, and perhaps lags in the reali-zation that demand will be increased, and even newproductive facilities created, installed, and broughtup to speed. The ultimate technological constraintto putting unemployed to work more rapidly in theprivate sector may reside in a limited capacity inthe capital goods industries such as construction,cement, and machine tools.

In any case much will depend on the degree of con-dence that can be engendered in the proposed in-crease in demand. It might be wise to start slowly,with a reduction of unemployment by say 0.5% therst year, and increasing to say 1% per year as con-dence is gained. Possibly the growth rate should sub-sequently be reduced somewhat as full employmentis approached, allowing for the increasing dicultyof matching workers to vacancies. It is mainly at

the later stages of the approach to full employmentthat training and improving the organization of the

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labor market may become needed. In the face of apolicy of maintaining a xed NIARU, workfareefforts to retrain and assist welfare clients amountto assistance in the playing of a cruel game of mu-sical chairs.

Such a NIARRU is likely to prove somewhat volatileand dicult to predict, and in any case it might provedesirable to push to full employment somewhat

faster than would be permitted by an unalteredNIARRU. This would call for the introduction ofsome new means of ination control that does notrequire unemployment for it to be effective. Indeed,if we are to control three major macroeconomicdimensions of the economy, namely the inationrate, the unemployment rate, and the growth rate,a third control is needed that will be reasonablynon-collinear in its effects to those of a scal policyoperating through disposable income generationon the one hand, and monetary policy operating

through interest rates on the other.

What may be needed is a method of directly control-ling ination that do not interfere with free marketadjustments in relative prices or rely on unemploy-ment to keep ination in check. Without such acontrol, unanticipated changes in the rate of ina-tion, either up or down, will continue to plague theeconomy and make planning for investment di-cult. Trying to control an economy in three majormacroeconomic dimensions with only two instru-ments is like trying to y an airplane with elevatorand rudder but no ailerons; in calm weather andwith sucient dihedral one can manage if turns aremade very gingerly, but trying to land in a cross-wind is likely to produce a crash.

One possible third control measure would be a sys-tem of marketable rights to value added, (or grossmarkups) issued to rms enjoying limited liability,proportioned to the prime factors employed, suchas labor and capital, with an aggregate face valuecorresponding to the overall market value of the

output at a programmed overall price level. Firmsencountering a specially favorable market could

realize a higher than normal level of markups onlyby purchasing rights from rms less favorably si-tuated. The market value of the rights would varyautomatically so as to apply the correct downwardpressure on markups to produce the desired overallprice level. A suitable penalty tax would be leviedon any rm found to have had value added in excessof the warrants held.

In any case it is important to keep in mind that di-vergences in the rate of inationeither up or down,from what was previously expected, produce merelyan arbitrary redistribution of a given total product,equivalent at worst to legitimized embezzlement,unless indeed these unpredictable variations are soextreme and rapid as to destroy the usefulness ofcurrency as a means of exchange. Unemployment,on the other hand, reduces the total product to bedistributed; it is at best equivalent to vandalism,and when it contributes to crime it becomes the

equivalent of homicidal arson. In the U.S. the wides-pread availability of automatic teller machines insupermarkets and elsewhere would make the shoe-leather cost of a high but predictable ination ratequite negligible.

Many profess a faith that if only governments wouldstop meddling, and balance their budgets, free ca-pital markets would in their own good time bringabout prosperity, possibly with the aid of soundmonetary policy. It is assumed that there is a marketmechanism by which interest rates adjust promptlyand automatically to equate planned saving andinvestment in a manner analogous to the market bywhich the price of potatoes balances supply and de-mand. In reality no such market mechanism exists;if a prosperous equilibrium is to be achieved it willrequire deliberate intervention on the part of mo-netary authorities.

In the heyday of the industrial revolution it wouldprobably have been possible for monetary authori-ties to act to adjust interest rates to equate aggregate

planned saving and aggregate planned investment atlevels of GDP growing in such a fashion as to produce

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and maintain full employment. Generally, however,monetary authorities failed to recognize the needfor such action and instead pursued such goals asthe maintenance of the gold standard, or the valueof their currency in terms of foreign exchange, orthe value of nancial assets in the capital markets.The result was usually that adjustments to shockstook place slowly and painfully via unemploymentand the business cycle.

Current reality: The time is long gone, however,when even the lowest interest rates manageableby capital markets can stimulate enough prot-mo-tivated net capital formation to absorb and recycleinto income over any extended period the savingsthat individuals will wish to put aside out of a pros-perity level of disposable personal income. Trendsin technology, demand patterns, and demographicshave created a gap between the amounts for whichthe private sector can nd protable investment

in productive facilities and the increasingly largeamounts individuals will attempt to accumulate forretirement and other purposes. This gap has be-come far too large for monetary or capital marketadjustments to close.

On the one hand the prevalence of capital savinginnovation, found in extreme form in the telecom-munications and electronics industries, high ratesof obsolescence and depreciation, causing a sharpdecline in the value of old capital that must be madegood out of new gross investment before any netincrease in the aggregate market value of capitalcan be registered, together with shifts from heavyto light industry to services, have sharply limitedthe ability of the private sector to nd protableplacement for new capital funds. Over the past ftyyears the ratio of the market value of private capitalto GDP has remained, in the U.S., fairly constant inthe neighborhood of 25 months.

On the other hand, aspirations for asset holdingsto nance longer retirements at higher living stan-

dards have increased sharply. At the same time theincreased concentration of the distribution of in-

come has increased the share of those with a highpropensity to save for other purposes, such as theacquisition of chips with which to play high stakesnancial games, the building of industrial empires,the acquisition of managerial or political clout, theestablishment of a dynasty, or the endowment ofa philanthropy. This has further contributed to arising trend in the demand of individuals for assets,relative to GDP.

The result has been that the gap between the privatesupply and the private demand for assets has cometo constitute an increasing proportion of GDP. Thisgap has also been augmented by the foreign tradecurrent account decit, which corresponds to a di-minution of the stock of domestic assets available todomestic investors. For an economy to be balancedat a given level of GDP requires the provision ofadditional assets in the form either of governmentdebt or net foreign investment to ll this growing

gap. The gap is now tentatively and roughly estima-ted for the U.S. to be equal to about 13 months ofGDP. There are indications that for the foreseeablefuture this ratio will tend to rise rather than fall.This is in addition to whatever role social securityand medicare entitlements have played in providinga minimal level of old age security.

In the absence of change in the ow of net foreigninvestment, a government recycling of incomethrough current decits of somewhat more thanthe desired growth in nominal GDP will be needed tokeep the economy in balance. Curtailing decits willcorrespondingly stie growth. A balanced budget,indeed, would tend to stop growth in nominal GDPaltogether, and in the presence of ination wouldlead to a downturn in real GDP and a correspondingincrease in unemployment.

Depending in part on what may happen at the stateand local levels, current programs for graduallyreducing the Federal decit to zero over the nextseven years would in effect put a cap on total go-

vernment debt at about 9 trillion dollars, implyingthat GDP would, in the absence of changes in net

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taking up part of the burden may vanish rathersuddenly, and all construction come to a grindinghalt. Debt becomes a strong inhibitor of growth.While this result may resemble that claimed by thecrowding out theory, the mechanism is not oneof displacement but of disincentive.

With a sales or value-added tax as the mainstay,a decit involving a reduction in tax rates today

will have no depressing effect on capital values andwill have a fully stimulating effect, through the in-crease in the aggregate supply of assets, possiblyreinforced by anticipatory spending motivated byexpectations that taxes may have to be higher at alater date to nance the debt service. There will beno Ricardian equivalence effect; if anything antici-pation of higher future taxes will encourage currentspending, adding to the stimulus of the increasedsupply of securities.

The U.S. Federal tax system is dominated by theincome tax, for which the effect will be somewhatintermediate between taxes on savings and taxes onexpenditure. In practice few individuals will haveany clear idea of the taxes likely to be imposed in thefuture as a result of the existence of a larger debt,and it can be safely said that no reasoned Ricar-dian equivalence phenomenon will occur, thoughthere may be some generalized malaise among theviewers with alarm, involving a kind of partiallyself-fullling prophecy.

The value of the national currency in terms of fo-reign exchange (or gold) is held to be a measure ofeconomic health, and steps to maintain that valueare thought to contribute to this health. In somequarters a kind of jingoistic pride is taken in the va-lue of ones currency, or satisfaction may be derivedfrom the greater purchasing power of the domesticcurrency in terms of foreign travel.

Reality: Freely oating exchange rates are the meanswhereby adaptations are made to disparate price

level trends in different countries and trade im-balances are brought into line with capital ows

appropriate to increasing the overall productivityof capital. Fixed exchange rates or rates conned toa narrow band can be maintained only by coordi-nated scal policies among the countries involved,by imposing eciency-impairing tariffs or otherrestraints on trade, or by imposing costly disciplinesinvolving needlessly high rates of unemployment, asis implied by the Maastricht agreements. Attemptsto restrain foreign exchange rates by nancial mani-

pulation in the face of a basic disequilibrium usuallybreak down, eventually, with large losses to theagencies making the attempt and a correspondinggain to agile speculators. Even short of breakdown,much of the volatility of foreign exchange rates canbe traced to speculation over possibilities of massivecentral bank intervention.

Restraints on exchange rates, such as are involvedin the Maastricht agreements, would make it vir-tually impossible for a small open economy, such as

Denmark, to pursue an effective full-employmentpolicy on its own. Much of the increase in purcha-sing power generated by a stimulative scal policywould be spent on imports, spreading the stimu-lating effect over the rest of the monetary unionso that Denmarks borrowing capacity would beexhausted long before full employment could beachieved. With exible exchange rates the increaseddemand for imports would cause a rise in the priceof foreign currency, checking the import increaseand stimulating exports so that most of the effects ofan expansionary policy would be kept at home. Thedanger of wild speculative gyrations under freelyoating conditions would be greatly diminishedunder a well-established full-employment policy,especially if combined with a third dimension ofdirect control over the overall domestic price level.

Similarly, the main reason states and localities can-not pursue an independent full employment policyis that they lack an independent currency, and areconstrained to have a xed exchange rate with therest of the country.

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It is claimed that exemption of capital gains fromincome tax will promote investment and growth.

Reality: Any attempt to dene a special category ofincome entitled to differential treatment is an invi-tation to the sorcerers apprentices in Congress andin the oces of the IRS to start casting spells that arebound to produce surprising consequences. Attemp-ting to draw up administrable rules dening econo-

mically meaningful lines between interest creditedto accounts but not drawn on, zero coupon bonds,stock appreciation from undistributed prots, in-ationary gains, prots from insider trading, gainsfrom speculation in land, gambles on derivatives,prots or losses on speculative ventures and so onis a sysyphean task. Taxpayers techies can then getbusy ferreting out shortcuts through the resultinglabyrinth to the detriment of the revenue and alsoof economic eciency. Ten special provisions of thecode can be combined with one another in over a

thousand ways to produce results far beyond thecapacity of a Congressional committee and its staffto anticipate.

Concessions to gains must entail corresponding li-mitations on the deductibility of losses, lest there beintolerably large opportunities for arbitrage againstthe revenue. In an attempt to counter the skills ofthe taxpayers techies, the rules are likely to be moresevere on the deductibility of losses than liberalwith respect to gains, so as to produce a numberof situations where the Treasury is playing headsI win, tails you lose with the taxpayer. Even witheffectively parallel rules, reduced effective deduc-tibility of losses may well be more of a disincentiveto speculative investment than the attractiveness oflow taxes on gains in the event of success.

Most economically desirable investments take consi-derable time for the anticipated results to be reec-ted in the capital markets, and the promise of a taxconcession to be effective in a remote future andsubject to possible alteration by future legislatures

is likely to be of little weight in the calculation ofthe investor. In any case the personal income tax

on gains is levied after or below the market and hasits primary effect on the disposable income of theinvestor, and relatively little effect on the capitalmarket from which the funds for capital formationare derived.

In practice, many capital gains arise from transac-tions of negligible or dubious social merit. Gainsderived from speculation in land add nothing to

the supply of land, and much of the gains fromsecurities trading based on advance information,whether or not characterizeable as insider trading,do no more to enhance productivity or investmentthan winnings from betting on basketball games.Attempts to exclude gains from speculation by li-miting concessions to assets held for longer periodsnot only introduce new complexities in determiningthe holding period in cases of rollovers, reinves-ted dividends, and other trades, but aggravate thelock-in effect as realization is deferred to obtain the

concession, an effect especially severe in the case ofthe total exemption from income taxation of gainson property transferred by gift or bequest.

Any increase in disposable income resulting fromlower capital gains taxation is likely to accrue toindividuals with a high propensity to save. If theproposal is advanced on a revenue neutral basis, thereplacement revenues are likely to have a greaterimpact on consumption demand, so that the netoverall effect of making concessions to capital gainsmay be to reduce demand, sales, and investment inproductive facilities. The main driving force behindthe proposals may well be as a pretext for providingwindfalls to persons who can contribute to campaignfunds as well as added commissions for brokers.

Some have argued for reductions in capital gainsrates rather than full exemption, pointing to surgesin revenue from the re sale spate of realizationsto take advantage of the new and possibly short-livedtax bargains. If this is done on a current-revenue-neutral basis, there may be some one-time stimulus

to the economy and to investment, resulting fromwhat would be an increase in the effective decit

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as viewed from a longer term perspective, but thiswill be small, temporary, and counterproductivein the long run.

A far more effective measure would be to reduceor eliminate the corporate income tax, which is ineffect a tax above the market, constituting an ad-ditional hurdle that prospective equity-nancedinvestments must face, as contrasted to the below-

or after-market impact of capital gain concessions.In addition to this double-whammy impact on theeconomy whereby the tax both abstracts from dis-posable income and also discourages investment,the tax has numerous defects in distorting invest-ment allocation, encouraging thin equity nancingwith consequent increased incidence of bankrupt-cies, and complicating tax laws. Unfortunately anysuch elimination is likely to be opposed not only bythose making a living from the complexities but bymany who variously believe rmly that its burden

falls on someone other than themselves. Actually inmost plausible scenarios the chief burden will be onwage earners. If considered as a substitute for othertaxes on a revenue-neutral basis, it would increasecurrent unemployment. If current employment isassumed to be maintained by an appropriate scalpolicy, future labor productivity and wages will bedepressed by labor having less capital to work with.

One excuse sometimes offered for the impositionof a corporation income tax is that undistributedprots do not bear their fair share of the individualincome tax. Rather than retaining a tax on all cor-porate income, this consideration would call for acountervailing tax of say 2 percent per year on theaccumulated undistributed prots, as a rough equi-valent to an interest charge on the resulting deferralof the individual income tax on shareholders. Thiswould be rough at best, since it allows neither forvariations in the marginal rates payable by indivi-dual shareholders, nor for possible realization ofthe undistributed prots through sale of shares, butit would be far better than the inept and draconic

taxes on undistributed prots enacted briey du-ring the 1930s.

A more thoroughgoing removal of the distortingeffect of taxes on real investment could be accom-plished by assessing the individual income tax on acumulative basis, whereby a gross tax on the accu-mulated income to date (including interest creditedwith respect to past taxes paid on this income) iscalculated by reference to tables that would takethe period covered into account. The accumulatedvalue, with interest, of taxes previously paid on this

income is then credited against this gross tax. Provi-ded that all income is eventually brought to account,the ultimate tax burden will be independent of thetiming of realization of income; about two-thirds ofthe internal revenue code and regulations wouldbecome superuous. The playing eld would beeffectively leveled; equitable treatment would be af-forded both to those realizing large gains in a singleyear and to those having to retire after a brief careero high earnings, a group not adequately dealt withunder most other averaging schemes. Bias against

investments yielding uctuating or risky returnswould be largely eliminated. Decisions as to whento sell assets to realize gains or losses or when todistribute dividends could be made purely on thebasis of appraisal of market conditions without ha-ving to consider tax consequences. Hordes of taxtechies could turn their talents to more productiveactivities.

Taxpayer compliance would be greatly simplied.The actual computation of the cumulative tax andtax payable requires only six additional entries onthe return, three of which are items simply copiedfrom a preceding return. As an introductory mea-sure, cumulative assessment could be limited tothose subject to rates above the initial bracket.

Debt would, it is held, eventually reach levels thatcause lenders to balk with taxpayers threateningrebellion and default.

Relevant reality: This fear arises in part from ob-serving crises in which capital-poor countries have

had diculty in meeting obligations denominatedin a foreign currency, incurred in many cases to

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nance imports and ultimately requiring servicingand repayment in terms of exports, the crisis oftenarising because of a collapse in the market for theexports. In the case at hand the debt is intended tosupply a domestic demand for assets denominatedin the domestic currency, and in the absence of anorm such as a gold clause, there can be no questionof the ability of the government to make paymentswhen due, albeit possibly in a currency devalued by

ination. Nor can there be any question of balkingby domestic lenders as long as the debt is limitedto that needed to ll a gap created by an excess ofprivate asset demand over private asset supply.

It is not intended that the domestic government debtshould be held in any large quantity by foreigners.But should foreigners wish to liquidate holdings ofthis debt or any other domestic assets, they can onlydo so as a whole by generating an export surplus,easing the domestic unemployment problem, re-

leasing assets to supply the domestic demand, andmaking it possible to get along with smaller decitsand a less rapidly growing government debt. Thesame thing happens if domestic investors turn toinvesting in foreign assets, thereby reducing theirdrain on the domestic asset supply.

In a panicky market it might happen that the marketprice of assets might fall suciently rapidly so thatthe total market value of the assets available to meetthe domestic demand might fall. In such a case atemporary increase in government decits ratherthan a decrease would be in order. Arranging thison short notice may be dicult, and the danger ofoverreacting or poor timing is real. Something morethan mere pious declarations that the economy isfundamentally sound, however, is called for. Never-theless one cannot entirely rule out the possibilityof this becoming a panic-generating self-fulllingprophecy derived from concentrating attention onthe nancial symbols rather than the underlyinghuman reality. In Roosevelts terms, the main thingto fear is fear itself.

Authorizing income-generating budget decitsresults in larger and possibly more extravagant,wasteful and oppressive government expenditures.

Reality: The two issues are quite independent, inspite of the fact that many anarcho-libertariansappear to have been using the ideology of budget-balancing as a way to put a strait-jacket on govern-ment activity. A government could run a decit with

no activity at all other than borrowing money byissuing bonds, paying out the proceeds in old-agepensions, and levying taxes sucient to cover anynet debt service. The issue of what activities areworth while for the government to carry on is atotally different issue from what the governmentcontribution to the ow of disposable income needsto be to balance the economy at full employment.

Government debt is thought of as a burden handedon from one generation to its children and grand-

children.

Reality: Quite the contrary, in generational terms,(as distinct from time slices) the debt is the meanswhereby the present working cohorts are enabledto earn more by fuller employment and invest inthe increased supply of assets, of which the debt isa part, so as to provide for their own old age. In thisway the children and grandchildren are relieved ofthe burden of providing for the retirement of thepreceding generations, whether on a personal basisor through government programs.

This fallacy is another example of zero-sum thinkingthat ignores the possibility of increased employmentand expanded output. While it is still true that thegoods consumed by retirees will have to be pro-duced by the contemporary working population,the increased government debt will enable more ofthese goods to be exchanged for assets rather thantransferred through the tax-benet mechanism.

In some ways the result of such decit nancing is

analogous to the extension of a social security reti-rement scheme to provide added benets to middle

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and upper incomes beyond the existing caps to thewages and earnings subject to social security contri-butions and the corresponding benets. There areimportant differences, however. The Social SecuritySystem is indeed often criticized as being in effecta kind of Ponzi scheme in which benets to earliercohorts are nanced by taxes on later cohorts. Thescheme is kept from collapsing by virtue of its beingcompulsory so that there will always be succeeding

cohorts to foot the bill, though possibly by higher orlower tax rates, unlike private schemes which tendto collapse when it is discovered that the emperorhas no clothes and new contributors shy away.

This Ponzi element was, however, necessary to getthe program off the ground during the depression.Had an attempt been made to establish the system on[...-ed.?] ortunately any such elimination is likely tobe opposed not only by those making a living fromthe complexities but by many who variously believe

rmly that its burden falls on someone other thanthemselves. Actually in most plausible scenarios thechief burden will be on wage earners. If consideredas a substitute for other taxes on a revenue-neutralbasis, it would increase current unemployment. Ifcurrent unemployment is assumed to be maintainedby an appropriate sliest [...-ed.?], retirees weregiven pension payments far beyond what wouldhave been nanced by their contributions and onlya relatively small reserve fund was accumulated toallow for adventitious differences between receiptsand outlays. Even so, the relatively brief lag betweenthe onset of social security contributions out of pay-rolls and the beginning of substantial payments toretirees constituted a withdrawal from purchasingpower, aggravated by the exclusion of the revenuein computing the formal decit, adding to pressureto reduce governments net addition to purchasingpower, and to overall pessimism stemming fromthe perception of decits as symptoms of economicill-health. These impacts substantially aggravatedthe drop in industrial production in the fall of 1937,by far the sharpest ever recorded.

Currently the amount by which the present value ofexpected future payments to current participantsexceeds that of expected future contributions bythem is a real liability of the government that isprobably at least as inescapable as that representedby the formal debt. While the schedules of paymentsare subject to alteration by act of Congress, whetherby changing the age of retirement, or subjectingmore of the payments to income tax, or otherwise,

political pressures are likely to require at least somedegree of indexation for ination, so that on balancethe real burden is likely to prove as unavoidable areal entitlement obligation as that of the formaldebt, which is to a much greater extent subject topossible erosion through accelerated ination. Theamounts are not small; one estimate has put the ca-pital value of governments entitlements, includingmilitary and civil service pensions, at over 3 years ofGDP, though such estimates are necessarily subjectto a wide range of uncertainty.

The situation could be formally regularized by abookkeeping entry that would add to the assets ofthe social security system and to the explicit liabi-lities of the government. However, this would be apurely formal move that should in principle be ofnegligible practical signicance, though a Congressobsessed with reducing the formal decit mightseize upon this recognition of a liability as an excusefor further inappropriate budgetary stringency. Inany case the macroeconomic impact is measurednot by the magnitude of the government liability,however calculated, but by the value placed on theseentitlements by the potential beneciaries in makingdecisions as to saving and consumption.

Many have even complained that the investment ofthe small actual social security reserves in specialgovernment securities amounts to the diversion ofsocial security contributions to government expen-diture. But the situation would be no different ifthe social security administration were to invest inprivate securities instead, with the private insurance

industry switching its reserve funds from private togovernment securities. The only real impact of mo-

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ving the social security system off budget wouldlie in the reaction of Congress to the enlargement ofthe nominal decit by the disregarding of the growthin the social security reserve. Should the Congressreact to offset this increase by budget tightening,the result would be an increase in unemploymentproduced as a result of a national rescuing of thesocial security reserve from being squanderedin government expenditure.

Setting aside as, irremediable bygones, the subsi-dizing of the earlier cohorts, for those currentlypaying payroll taxes the relevant reality (as distinctfrom arbitrary accounting conventions) is that therelation between the taxes paid by or on behalf ofany individual and the present expected value offuture benets is extremely loose. Overall, if onewere to apply the rules currently on the books to asteady demographic state of a constant populationwith a constant expectation of life, with the relatively

small social security reserve fund kept at a constantlevel, present value of benets payable to a givencohort would fall short of the net present value of thetaxes paid during its working life by the differencebetween the interest that would have been earnedby a full actuarial reserve and the smaller amountof interest paid on the recorded reserve. From thisviewpoint, looking only at the future, there wouldthus be a net contribution from the social securitysystem to the general purpose sc, much larger, ac-tually, than the amount involved in the charge thatthe addition to the small nominal reserve is beingimproperly appropriated to current governmentexpenditures.

In terms of actual demographic changes, a growingpopulation and a lengthening expectation of life bothmean that if the reserve fund were held constant,current cohorts still gain at the expense of latercohorts. In practice this is somewhat modied bydifferentials between total current tax revenues andtotal current benet payments, reected in uctua-tions in the reserve fund.

Within each cohort, the often arbitrary and evencapricious operation of the complex formulas bywhich benets are determined mean that the re -lation between taxes paid at any given time by agiven individual and the consequent increase inexpected eventual benets varies widely and oftencapriciously. At one extreme, many of those whoaccumulate less than 40 quarters of covered em-ployment over their working life will not become

eligible for any benets; their contributions are ef-fectively a tax on their wages, whether nominallypaid by themselves or their employer. Examples arewomen who start work at 18 but marry and leavethe labor force at 25, or empty nesters who enterthe labor force for the rst time at age 54 or later;for such persons squeezing in a fortieth quarter ofcoverage could be extremely lucrative.

Even for most of those who do become eligible, thereis an arbitrary exclusion from the formula of the ve

years of lowest indexed annual covered earnings,so that for these years the contributions are againa pure tax. This is particularly unfortunate in thatthese lowest years are in most cases the earliest yearsof employment, at ages for which unemploymentrates are highest, and the effects of the tax mostunfortunate.

Benets are not paid on the basis of taxes paid buton the basis of covered wages, which means thatthose employed during years in which tax rateswere low obtain benets as though they had paidtaxes at the later higher rates. On the other hand,in computing benets wages are indexed, not by aprice index or by a compound interest factor, butby a nationwide average wage, which has tendedto grow at a rate signicantly below an appropriaterate of interest. The result is that over a period ofconstant tax rates, taxes on earlier wages purchasefewer benets in terms of present value than thoseon later wages.

Benets are determined on a fairly steeply progres-

sive basis, being roughly 90 percent of the rst $5,000of the individuals average indexed annual wages,

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32 percent of wages between $5,000 and $30,000,15 percent between $30,000 and $60,000, and zeroabove $60,000. The result is a fairly substantial trans-fer from high-wage earners to low-wage earners.Low-wage earners may actually receive, as a group,benets exceeding in present value that of the pay-roll taxes paid on their earnings, while a relativelylarge part of the payroll taxes paid on higher wageswould be effectively a tax rather than a premium.

Because of this low return in terms of benets ontaxes on wages in the $30,000-$60,000 bracket, thefact that no payroll taxes are levied on wages abovethis $60,000 cap produces a highly anomalous dip inthe combined marginal effective tax rate on earningsas earnings rise above this cap. Not only is this inver-sion of progression inecient in term of incentives,it even opens the door to an arrangement wherebyan employer would agree with his employee to pay$20,000 and $100,000 in alternate years, instead of

a constant $60,000. This would reduce the payrolltaxes payable while producing only a relativelyminor reduction in expected benets. This mightbe partially offset by consequent increases in theindividuals income tax unless some countervailingshifting of other income can be devised.

The impact of the social security system on the ba-lance between the demand for and supply of assetsand on employment is thus fairly complex. Howe-ver, it does not depend so much on the intricaterealities of the system as on the way it is perceived,both by its participants and by Congress. Many inCongress seem bemused by wildly irrelevant rheto-ric concerning the supposed diversion of surplussocial security revenues to government expenditure,and contentions over whether the system shouldbe considered off budget or on. Most payroll tax-payers are only dimly aware of the relation of theircontributions to eventual benets. Most youngerwage earners probably pay little attention to theprospect of benets several decades in the future,and tend to treat their contribution as entirely a tax,

though perhaps persisting under the delusion that

the employers share of the tax is actually borneby the employer.

Older low-wage workers are perhaps more likelyto take future benets into consideration in deter-mining their attitude towards payroll taxes, expec-tations of benets and decisions on the level of ex-penditure. High-wage earners, on the other hand,may be more likely to regard payroll contributions

as a tax, encouraged, in many cases, by propagandashowing how their contributions, if invested ins-tead on an individual basis in private pensions orannuities, could yield substantially greater benets,so that social security appears to be a bad bargainfor them.

Another way of looking at it is to inquire what theequivalent is, in terms of individual wealth, of theinterest of clients in the system. On the one handthe level of future benets is not guaranteed, but

is subject to modication by Congress, such as bysubjecting benets to individual income tax, in-creasing the normal age of retirement in terms ofwhich benets are calculated, increasing the cap ontaxable wages, or even changing the benet formu-las themselves. While there is no guaranteed mini-mum below which benets cannot be reduced, thepolitical reality seems to be that taxpayers can relyon a fairly substantial wealth-equivalence. There iseven a fairly well-established practice of indexingbenets by the consumer price index, so that socialsecurity wealth is likely to be less impaired by in-ation than investment in long-term governmentsecurities.

Also, social security wealth is much less heavilyconcentrated among middle and upper classes thanwealth in general, and thus tends to have a greaterfavorable inuence on the level of consumptionexpenditure.

Unemployment is not due to lack of effective de-mand, reducible by demand-increasing decits, but

is either structural, resulting from a mismatchbetween the skills of the unemployed and the re-

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quirements of jobs, or regulatory, resulting fromminimum wage laws, restrictions on the employ-ment of classes of individuals in certain occupations,requirements for medical coverage, or burdensomedismissal constraints, or is voluntary, in part theresult of excessively generous and poorly designedsocial insurance and relief provisions.

Current situation: To anyone acquainted with labor

market conditions, it is abundantly apparent thata large proportion of those currently ocially re -gistered as unemployed, as well as large numberswho are not, are ready and able to take most, if notall, of the kinds of jobs that would be opened up byan increase in market demand. In the absence ofsuch an increase, at current levels of unemployment,attempts to move selected unemployed individualsor groups into jobs by training, instruction in jobsearch techniques, threats of benet withdrawal ordenial, and the like, merely move the selected indi-

viduals to the head of the queue without reducingthe length of the queue. Merely because any onetraveler can secure a seat on a ight by getting tothe airport suciently early does not mean that ifeveryone gets to the airport suciently early that200 passengers can get on a ight with seats for 150.

Even if jobs are specically created for selectedclients, as by facilitating the opening of a new shop orbusiness, while there may be a temporary stimulusto the economy from whatever capital investment isinvolved, ultimately in many cases this will merelydraw purchasing power from other establishments,resulting in reduced sales, reduced capital value,and eventually reduced employment elsewhere.Only if some element of novelty tempts consumersto spend additional amounts, impinging on theirplanned savings, or if workfare involves produ-cing a free public good or service enhancement thatdoes not compete for purchasing power or replaceother public employment, will there be any net re-duction in unemployment. But while such publicworks programs can indeed convert unemployed

labor into improved public amenities and facilitiesof various types, as long as they are nanced on the

basis of an unchanged decit, any further impacton the economy as a whole will be limited to thedifference between the appending rate of those de-riving income from the program and the spendingrate of those paying the taxes to nance it.

Aside from such a public works program, the re-sult of attempts to push people into jobs is simply avast game of musical chairs in which local agencies

instruct their clients in the art of rapid sitting, withworkfare curmudgeons threatening to conscatethe crutches of the unsuccessful, while Washingtonis busy removing the chairs by decit slashing.

As for voluntary unemployment, much of thiswould disappear as demand and activity increases,and over-qualied workers move up out of low-skill

jobs into the expanding demand for higher skills,leaving more openings for low-skilled unemployedto ll, and removing the depressing effect of high

unemployment levels on low-skill wages. Wages forlow-skill but necessary jobs would tend to increase,raising them suciently above the safety-net level tomitigate the adverse incentives of the welfare state.Higher wages would raise the prices of low-skillproducts, increasing the measured productivityof such jobs and diminishing the stigma attachedto them as low-productivity or dead-end jobs.Prices of high-skill products may fall to offset this,possibly as a result of technological advance oreconomies of scale, but if not there may be a smallone-shot increase in the cost of living. This wouldstill be a small price to pay for the benets of fullemployment. It should not be assumed that this isthe beginning of an inationary spiral.

To be sure, there are horror stories of individualswho quite rationally decline employment because ofthe combined impact of the resulting reductions invarious means-tested welfare benets, increases intaxes and social security contributions, and travel,child care, and other costs associated with employ-ment. To a considerable extent this is the result of

designing a variety of welfare and income-depen-dent programs independently of each other without

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regard to interactions and combined effects. As eachmeans-tested program is set up separately, the bene-ts tend to be phased out or capped in ways designedto keep the direct costs attributed to the particularprogram or measure down. These phase-outs andcaps may seem quite reasonable when consideredseparately, but when several of them happen tooverlap the combined results create absurdly higheffective marginal tax rates. Slower phase-outs

are called for, even if that increases the budgetedcost of the programs.

In many cases there is no overall justication forany phase-out. In the case of the earned incomecredit, for example, eliminating the phase-out andrecouping the revenue by increases in marginalrates on upper income brackets would result in asmoother pattern of effective marginal rates withsmaller overall disincentive effects and a conside-rable simplication of tax forms and reduction in

compliance costs. The existing law seems to havearisen because the earned income credit was enac-ted as a patch on the pre-existing law, subject to ataboo against raising nominal marginal rates, whilethe raising of effective marginal rates by the phase-out could get by. Political posturing and the arcanemechanics of the legislative process prevented arational examination of the tax structure as a whole.

Ready availability of jobs at respectable wages wouldmake it easier to deny benets to those unduly -nicky about the type of employment they will accept,and reduce the need for severance pay and otherforms of featherbedding. Real full employmentwould also reduce the pressure for protectionism, re-sistance to the .abandonment of redundant militaryinstallations and other obsolete activities and make

job security generally less of an issue. Real full em-ployment would also encourage employers to com-pete in arranging work schedules and workplacearrangements to accommodate those with familyobligations or other constraints, and otherwise paymore attention to improvement of working condi-

tions. There will be less need for minimum wagelaws and other government regulation of working

conditions, and less diculty in the enforcementof those that there are.

These fallacious notions, which seem to be widelyheld in various forms by those close to the seats ofeconomic power, are leading to policies that arenot only cruel but unnecessary and even self-de-feating in terms of their professed objectives. Insome quarters there seems even to be a move on

towards declaring prosperity and taking steps toprevent the economy from overheating or brin-ging on a higher ination rate. The CongressionalBudget Oce, indeed, echoing the prevailing moodin Washington, appears satised with projectionsthat involve unemployment rates continuing at closeto 6 percent indenitely. To those with even a mi-nimal concern with the plight of the unemployedand the homeless, such an attitude appears callousin the extreme.

We will not get out of the economic doldrums aslong as we continue to be governed by fallaciousnotions that are based on false analogies, one-sidedanalysis, and an implicit underlying counterfactualassumption of an inevitable level of unemployment.Worse, we may well be in a situation comparable to1926 when according to the orthodoxy of the day thedebt accumulated during WW I was something tobe retired as rapidly as possible. Accordingly, pur-chasing power was taken from the income streamby taxes and used to retire the debt. The amountspaid out to retire bonds were not considered bythe recipients as income to be spent, so that consu-mer demand grew insuciently to maintain thelevel of employment, and unemployment increasedconsiderably from 1926 to 1928 to 1929. Instead,the proceeds were used to bid up asset prices. Fora time this slowing of growth was moderated bythe euphoria created by the corresponding accrualof capital gains and the resulting enhanced rate ofspending. But even the easier nancing affordedby the higher price/earnings ratios of stocks couldnot induce much capacity expansion beyond the

ability of demand to provide protable sales, andwhen it was realized that further increases in assert

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prices could not be justied by the slower increasesin the demand for products, capital gains ceased toaccrue and the system collapsed into the depressionof the 1930s.

The parallel of today is that although we are notactually retiring debt, in relation to current condi-tions decit cutting is a comparable reduction in thenet contribution of the government to disposable

income. In its projections the CBO appears to dis-count almost entirely the effect of a diminution ofthis recycling on the level of activity. On the contrary,the CBO assumes that if this recycling is furtherreduced by a budget balancing program the resultwill be a slight increase in the growth rate of GDPby 0.1 percent per year, rather than a decrease (TheEconomic and Budget Outlook, May, 1996, pp. 1-3).

Apparently it was assumed that the reduction inthe decit will induce the Federal Reserve Board

to lower interest rates, and that this will lead to anincrease in investment activity. But it seems unli-kely that there is anything the FRB would or coulddo that would overcome over any extended periodthe discouragement to investment inherent in thereduction of market demand resulting from the re-duction in government recycling of income. Thereis, indeed, a tendency to overstate the long-run ef-fect of interest rate changes on rates of investmentas a result of observing the short-to-medium-runresponses of investment ows to changes in interestrates. Once installed stocks of capital have reacheda level corresponding to the lower interest rate, fur-ther investment will fall to near its former rate. Thisis much as while the ow in the mill-race can beincreased for a time by lowering the top of the weir,the ow will fall back to its former level as soon asthe surface of the mill-pond has been lowered cor-respondingly. Action by the Federal Reserve Boardmay be able to postpone, but not to overcome, theconsequences of inadequate government recyclingof savings into income.

If a budget balancing program should actually becarried through, the above analysis indicates that

sooner or later a crash comparable to that of 1929would almost certainly result. To be sure, it wouldprobably be less severe than the depression of the1930s by reason of the many cushioning factorsthat have been introduced since, and enthusiasmfor the quest of the Holy Grail of a balanced budgetmay wane in the face of a deepening recession, butthe consequences of the aborted attempt would stillbe serious. To assure against such a disaster and

start on the road to real prosperity it is necessaryto relinquish our unreasoned ideological obsessionwith reducing government decits, recognize thatit is the economy and not the government budgetthat needs balancing in terms of the demand for andsupply of assets, and proceed to recycle attemptedsavings into the income stream at an adequate rate,so that they will not simply vanish in reduced in-come, sales, output and employment. There is too afree lunch out there, indeed a very substantial one.But it will require getting free from the dogmas of

the apostles of austerity, most of whom would notshare in the sacrices they recommend for others.Failing this we will all be skating on very thin ice.

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Www.columbia.edu Vickrey William 1996 15 Fatal Fallacies of Financial Fundamentalism