An Economic Conspiracy....

One of the interesting things about the recession is how there is a conspiracy of economists talking complete nonsense. The mainstream opinion is presented in most of the media, which says we have to slash interest rates, and print more money...although most ordinary people can see that is plain wrong. Anyway, I touched on some of the alternatives in my Money Week column last week. Here's a taster.

There are plenty of things from the early 1980s we’d rather not revive. No one really wants to drive around in a Ford Sierra, or watch the early episodes of Dynasty. But there is one thing from a quarter century ago that could be usefully bought back from the dead: Reagan-omics.
In the UK, there is a stultifying consensus among economists and pundits that the historical lessons we need to be learning are all from the 1930s. We need massive government spending, and the printing presses need to keep churning out new money, we are constantly told.
But, in truth, the decade the UK should be learning from is the 1980s. And the policy prescriptions should be the same ones that Ronald Reagan pushed through after moving into the White House in 1982: dramatically lower taxes and higher interest rates.
It is the exact opposite of what most experts are arguing for the UK. But it is the only mix that will get us out of the recession.
In the early 1980s, the US faced a global recession. Unemployment was rising fast, and so was inflation. Output was in decline. The government budget deficit was soaring out of control. Nobody appeared to have much of a clue how to pull the country out what looked like a severe economic downturn.
The conventional response, pushed by Keynesian economists, was to raise government spending on public works, let taxes steadily rise to keep the deficit under control, and get the Federal Reserve to push interest rates down to make money cheaper.
Sounds familiar? It is just about the same mix the UK is following today. In response to a global recession, the budget deficit is being allowed to soar out of control. The Bank of England is keeping interest rates at all-time lows, as well as printing money. A consensus across all parties is emerging that taxes will have to rise: all the Conservative Party can promise is that it will raise them a bit less. Indeed, from next year, the British top rate of tax will rise to 50%, one of the highest top rates in Europe. Many other tax rises are likely to follow.
Reagan’s genius was his ability to rip up consensus views, and try something radically different instead. And that’s precisely what he did on the economy.
Ignoring the Keynesian consensus in academia, and on Wall Street, Reagan radically cut tax rates. The Economic Recovery Tax Act of 1981 pushed down average income tax rates by a quarter: the top-rate came down from 70% to 50%, whilst the bottom rate dropped from 14% to 11%. At the same time, allowances were legally tied to inflation, and capital gains taxes were slashed.
But to make sure all those tax cuts didn’t spark inflation, the Chairman of the Federal Reserve under Reagan, Paul Volcker, also pushed up interest rates. From 11% in 1979, rates in the US went all the way up to a peak of 21.5% in 1982.
Most of the economic and business establishment thought Reagan was crazy. It was precisely the ‘voodoo economics’ his vice-president George Bush had complained about on the campaign trail. There were plenty of predictions of catastrophe. But it turned out to be right. Within a few years, not only had the US pulled out of recession. It had laid the foundations for what turned out to be a quarter century of growth, new jobs and rising prosperity.
In truth, what Reagan had done was create what supply-side economists call an ‘enterprise recovery’. The tax cuts stimulated entrepreneurs, whilst higher interest rates encouraged saving, allowing the deficit to be funded, and creating wealth that businesses could draw upon. Over the next decade, the American economy was re-built. Sure, there was some pain involved, but the policy was a resounding success.
There are plenty of lessons in that for Britain in 2009, if only we were open-minded enough to learn them.
Right now, we have cheap money, and the inevitability of rising taxes. The chances are that isn’t going to do much good. There is already evidence the tax rises needed to fund Gordon Brown’s so-called ‘stimulus’ will end up stunting the recovery instead. The Taxpayer’s Alliance produced a report this week showing that effectively money would be taxed at 92% before entrepreneurs got a chance to invest it. "Politicians are promoting a huge range of schemes to try and hold down unemployment but they aren't paying nearly enough attention to how their policies affect entrepreneurs, who create the vast majority of new jobs,” argued the Alliance’s research director Matthew Sinclair in the report.
True enough. Not just entrepreneurs are deterred. Ordinary consumers are nervous of future tax rises, and that will dampen both consumer and business confidence, two vital ingredients for any recovery. At the same time, interest rates are so low, it is virtually pointless for any sane person to save money. And what money is saved is going to be sucked up immediately by the government’s vast borrowing.
If Britain wanted a radical change of direction, it should do precisely what Reagan did in the early 1980s.
Step one, cut taxes dramatically.
A country with Swedish tax rates and Zimbabwean-style public services isn’t going to be able to compete. With the state consuming 50% of GDP there is no chance of sustained recovery. True, in the short-term the deficit will rise even higher. But if tax cuts are part of an ‘enterprise recovery’, the tax revenues will come along in due course to start paying down the debt, just as they did for Reagan.
Step two, let interest rates rise back to a normal, long-term
Once taxes are cut, monetary policy will need to be tightened to stop inflation running out of control. And the UK needs to start restoring a savings culture – and the only way to do that is to start rewarding thrift again. Tight money and low taxes, contrary to what the Keynesians will tell you, are naturally bedfellows, creating sustainable, non-inflationary growth.
For the UK economy to start recovering, it needs to save more, work harder, and create new industries. Reagan understood that was the only lasting recipe for economic success – and at some point, the British will need to re-learn it as well.