Tariffs, rising state and federal taxes, and currency devaluation ruined the 1930s, and they could do the same today.

By ARTHUR B. LAFFER

Wall Street Journal – SEPTEMBER 22, 2009 – link to original

The 1930s has become the sole object lesson for today’s monetary policy. Over the past 12 months, the Federal Reserve has increased the monetary base (bank reserves plus currency in circulation) by well over 100%. While currency in circulation has grown slightly, there’s been an impressive 17-fold increase in bank reserves. The federal-funds target rate now stands at an all-time low range of zero to 25 basis points, with the 91-day Treasury bill yield equally low. All this has been done to avoid a liquidity crisis and a repeat of the mistakes that led to the Great Depression.

Even with this huge increase in the monetary base, Fed Chairman Ben Bernanke has reiterated his goal not to repeat the mistakes made back in the 1930s by tightening credit too soon, which he says would send the economy back into recession. The strong correlation between soaring unemployment and falling consumer prices in the early 1930s leads Mr. Bernanke to conclude that tight money caused both. To prevent a double dip, super easy monetary policy is the key.

While Fed policy was undoubtedly important, it was not the primary cause of the Great Depression or the economy’s relapse in 1937. The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products. Huge federal and state tax increases in 1932 followed the initial decline in the economy thus doubling down on the impact of Smoot-Hawley. There were additional large tax increases in 1936 and 1937 that were the proximate cause of the economy’s relapse in 1937.

In 1930-31, during the Hoover administration and in the midst of an economic collapse, there was a very slight increase in tax rates on personal income at both the lowest and highest brackets. The corporate tax rate was also slightly increased to 12% from 11%. But beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That’s not a misprint!) The corporate rate was raised to 13.75% from 12%. All sorts of Federal excise taxes too numerous to list were raised as well. The highest inheritance tax rate was also raised in 1932 to 45% from 20% and the gift tax was reinstituted with the highest rate set at 33.5%.

But the tax hikes didn’t stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.

Because of the number of states and their diversity I’m going to aggregate all state and local taxes and express them as a percentage of GDP. This measure of state tax policy truly understates the state and local tax contribution to the tragedy we call the Great Depression, but I’m sure the reader will get the picture. In 1929, state and local taxes were 7.2% of GDP and then rose to 8.5%, 9.7% and 12.3% for the years 1930, ‘31 and ‘32 respectively.

The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I’d give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s. Net legislated state-tax increases as a percentage of previous year tax receipts are at 3.1%, their highest level since 1991; the Bush tax cuts are set to expire in 2011; and additional taxes to pay for health-care and the proposed cap-and-trade scheme are on the horizon.

In addition to all of these tax issues, the U.S. in the early 1930s was on a gold standard where paper currency was legally convertible into gold. Both circulated in the economy as money. At the outset of the Great Depression people distrusted banks but trusted paper currency and gold. They withdrew deposits from banks, which because of a fractional reserve system caused a drop in the money supply in spite of a rising monetary base. The Fed really had little power to control either bank reserves or interest rates.

The increase in the demand for paper currency and gold not only had a quantity effect on the money supply but it also put upward pressure on the price of gold, which meant that dollar prices of all goods and services had to fall for the relative price of gold to rise. The deflation of the early 1930s was not caused by tight money. It was the result of panic purchases of fixed-dollar priced gold. From the end of 1929 until early 1933 the Consumer Price Index fell by 27%.

By mid-1932 there were public fears of a change in the gold-dollar relationship. In their classic text, “A Monetary History of the United States,” economists Milton Friedman and Anna Schwartz wrote, “Fears of devaluation were widespread and the public’s preference for gold was unmistakable.” Panic ensued and there was a rush to buy gold.

In early 1933, the federal government (not the Federal Reserve) declared a bank holiday prohibiting banks from paying out gold or dealing in foreign exchange. An executive order made it illegal for anyone to “hoard” gold and forced everyone to turn in their gold and gold certificates to the government at an exchange value of $20.67 per ounce of gold in return for paper currency and bank deposits. All gold clauses in contracts private and public were declared null and void and by the end of January 1934 the price of gold, most of which had been confiscated by the government, was raised to $35 per ounce. In other words, in less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That’s one helluva tax.

The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer price index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that’s the story.

The lessons here are pretty straightforward. Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon.

My hope is that the people who are running our economy do look to the Great Depression as an object lesson. My fear is that they will misinterpret the evidence and attribute high unemployment and the initial decline in prices to tight money, while increasing taxes to combat budget deficits.

Mr. Laffer is the chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let It Happen” (Threshold, 2008).

by Joseph Y. Calhoun, III -

Sep 13th, 2009 - Alhambra Investment – link to original article

From the NY Times, June 28: “At a time when the economy worldwide is still deep in recession and we’ve seen a significant drop in global trade,” Mr. Obama said, “I think we have to be very careful about sending any protectionist signals out there.”

WASHINGTON, Sept 9 (Reuters) - The U.S. Commerce Department said on Wednesday it had imposed preliminary duties ranging from 10.90 percent to 30.69 percent on $2.6 billion of steel pipe from China used to transport oil.

WASHINGTON, Sept. 11 – The Obama administration will put steep import duties of 35% in the first year on Chinese passenger and light truck tires, responding to what the U.S. International Trade Commission determined to be a surge of Chinese tire exports that has rocked the domestic U.S. tire industry and displaced thousands of jobs, U.S. Trade Representative Ron Kirk announced Friday night.

So how should we interpret this? Does this mean the recession is over? Or does it mean that imposing two new tariffs in one week is not a giant, flashing neon protectionist signal? Or does it mean that we should be careful about sending protectionist signals but actually taking protectionist actions is okay? Does it mean that President Obama has decided to emulate the Bush administration he spent an entire campaign railing against and manages to blame for every ill facing the country? Does it mean, that unlike other Democrats, President Obama has a secret admiration for Herbert Hoover?

There are a lot of contentious subjects in economics, but one area of near unanimous agreement is free trade. Even partisan political hack economists who disparage their former colleagues from the pages of the New York Times favor free trade:

If economists ruled the world, there would be no need for a World Trade Organization. The economist’s case for free trade is essentially a unilateral case – that is, it says that a country serves its own interests by pursuing free trade regardless of what other countries may do. Or as Frederic Bastiat put it, it makes no more sense to be protectionist because other countries have tariffs than it would to block up our harbors because other countries have rocky coasts. So if our theories really held sway, there would be no need for trade treaties: global free trade would emerge spontaneously from the unrestricted pursuit of national interest.  Paul Krugman

President Bush flirted with protectionism in his first term when he imposed steel tariffs. The move was intended to save a few steel jobs – and garner a few votes – but the overall economic effect was negative due to the loss of jobs in steel consuming industries. The tariffs were ultimately declared illegal by the WTO so the net result of the policy was a loss of jobs, no political gain, higher steel prices and a violation of world trading rules. Why President Obama would expect different results this time is a mystery.

President Hoover, of course, signed the infamous Smoot Hawley Act which raised tariffs in 1930 and most economists agree was a major factor in the Great Depression. Economists may disagree about the degree to which the act influenced events, but it is hard - if not impossible - to find an economist who dismisses it as a contributor. Hoover actually initially opposed the bill because he had pledged international cooperation to combat the economic downturn, but in the end he bowed to the political pressure from his party – Republicans were the protectionists back then – and signed the bill. Sound familiar?

Protectionism is not sound economic policy and as Hoover and Bush found out, it isn’t even sound political policy. The steel unions to which Bush deferred didn’t support him in the next election and FDR attacked Smoot Hawley almost from the day it was signed. By the time the 1932 election rolled around, the effects of the tariffs were so obvious even the farmers Hoover sought to protect voted for FDR. President Obama may find the political benefits just as elusive. The Chinese are already considering how to retaliate and they don’t lack for options:

Sept. 13 (Bloomberg) — China announced a probe into the alleged dumping of American auto and chicken products, two days after U.S. President Barack Obama imposed tariffs on imports of tires from the Asian nation.

Chinese industries have complained that they’re being hurt by “unfair trade practices,” the nation’s Ministry of Commerce said on its Web site today. The ministry is also looking into subsidies for the products, it said. It didn’t specify the imports’ value.

So anything we gain in the trade in tires and steel pipes will be lost in autos and chickens or something else. This might be a good time to recall that one of the few places on the planet where GM sales are rising is China. Tariffs are taxes which are borne by the consumer so the big losers in this high stakes game are American consumers and companies who will pay higher prices for tires and steel pipe. There may be a marginal benefit to US steel and tire workers, but higher prices will mean less steel and tires sold so the idea that this will increase employment in those industries is debatable at best. The effect on jobs at companies who sell the imported tires is anyone’s guess, but it won’t be a positive number. One also shouldn’t be fooled into believing the tariffs will be beneficial to tire and steel company profits. The tire companies did not support these tariffs – the steelworkers union filed the complaint – because they manufacture tires in China. In other words, the President of the United States just imposed tariffs on US based companies. Are higher prices, lower profits, fewer jobs and reduced exports too high a price to pay for union support for health care reform? Apparently not for President Obama.

President Obama’s economic policies may be sold as a benefit to the working class and the poor, but the overall effect is just the opposite. Cash for clunkers raised the price of used cars that are bought primarily by the working poor and while it was also intended to benefit GM and Chrysler workers, one cannot help but note that both companies reported lower sales during the program period. The tire tariffs are aimed at low priced Chinese tires that are bought primarily by – you guessed it – poorer Americans. The recently enacted higher minimum wages limit the ability of young Americans and especially young, minority Americans to gain entry to the workforce. It is not a coincidence that youth unemployment is at an all time high, over 25%. Higher wage costs also tend to hurt small businesses more than larger ones and therefore limit new job creation. The last administration signed off on the higher minimum wage, but President Obama supported the policy in Congress so I guess he shares the same level of concern for the poor as former President Bush. Poor Americans cannot be helped by punishing poor Chinese or by making it more expensive to hire them.

The policies of the Federal Reserve and the Treasury since the last recession have also been conducted  – allegedly – with the average American in mind, but again it hasn’t worked out that way. The weak dollar policy of the Bush administration – continued by the Obama administration – was intended to correct a persistent trade deficit which many viewed – wrongly – as costing American jobs. The Fed’s maintenance of low interest rates was intended to keep the credit spigot open wide for all Americans during the last recession. The weak dollar policy pushed up the price of commodities and while all Americans pay the price at the pump and grocery store, the poor are hurt the most since a higher proportion of their earnings are dedicated to the purchase of these necessities. The low interest rate policy induced many Americans to take on debt they couldn’t afford, but again the hardest hit were the poor who took on loans they didn’t understand and never had a prayer of repaying for houses inflated in value, at least partially, by the weak dollar. The end result of these policies has cost more jobs than could ever be plausibly – or even implausibly - blamed on free trade or a lack of credit.

The bailouts of various financial institutions over the last two years were also sold as being in the best interests of average Americans. Saving too large to fail banks, brokers and insurance companies was seen as critical to maintaining access to credit for US businesses and consumers. Tried to get a loan recently? One begins to suspect that no matter what party is in power, policy is driven more by concern for campaign contributors than the well being of the nation as a whole. The special interests may change somewhat (although the financial industry seems to be bipartisan in its politician buying), the rhetoric may change, but political corruption is eternal and bipartisan.

There is a lot of debate now about the health of the US economy. Is the recession over? If so, how robust will the recovery be? How long will it last? Will we have a double dip? A triple dip? Over the last few months, I have consistently predicted a more rapid recovery than most commentators and to this point I think I’ve been proven correct. I have also consistently said that the quality of the recovery will leave a lot to be desired. The reason for that is that the improvement in the economic statistics is primarily due to the intentionally inflationary policies of the Federal Reserve. Inflation provides an illusion of economic growth, but it cannot produce real growth. Real growth is encouraged through all the other policies that affect economic performance – tax policy, trade policy, regulatory policy, etc. And on that front, I see little that can be called encouraging.

President Obama’s rhetoric produced an historic political victory, but his smooth delivery cannot substitute for good economic policy. Paying lip service to free trade while enacting policies that are proven beyond any reasonable doubt to be economically damaging will not fool the market. The dollar’s recent descent is a warning about current economic policy that should not be ignored as it was by the Bush administration. The nascent recovery in economic activity is not self sustaining and could be derailed quickly if supportive pro growth policies are not enacted soon. Setting off a trade war would be right at the top of a long list of things we can’t afford right now.