Economic ignorance hurts

Today, Fed Chairman Ben Bernanke testified on Capitol Hill before the House Budget Committee, giving prepared remarks and answering questions posed by lawmakers on the committee.

The proceedings were generally a cause for dismay. In fact, although no one ever knows the exact reasons for a market's movements on any given day (although the news media will confidently tell you that they do, which is nonsense), it is very possible that the markets were further rattled by the goings-on today in Congress.

The main thrust of the question-and-answer session was the issue of which would better assist the economy, rebates or tax cuts, with lawmakers using their questions more to make their own assertions on the topic and to get Bernanke to echo their opinions in a newsworthy soundbite than to hear what he had to say.

The question of tax rebate "stimulation" versus tax rate cuts is an excellent illustration of the very important conflict between the demand-side worldview and the supply-side worldview which we have discussed in numerous previous posts, most notably this one.

The mentality behind sending a tax rebate of, say, $800 dollars in the form of a check to every taxpayer ($1,600 to every taxpaying couple) is a classic demand-side attempt to "stimulate" the consumer (recall that in the previous blog posts we have also noted that demand-side thinking is also called "consumptionist" thinking). It is a very clear example of the thinking that "the consumer drives the economy."

On the other hand, the supply-side approach believes that the real engines of the economy are the business which produce goods and services (which is why it is also called "productionist" -- see the essay "Production versus Consumption" by economist George Reisman, first published in 1964). If the economy needs help, a productionist or supply-sider is much more inclined to recommend action that will enable the formation of new businesses, as well as enable greater investment (and ultimately greater production) in businesses which are already producing in the economy right now.

Greater investment in businesses creates more jobs, which stimulates demands far more than any $800 check will do. And, while demand-siders argue that the check is much faster, the primary tool of stimulating business formation and business investment -- cutting the tax rates on capital gains that result from successful investment in such businesses -- has immediate and dramatic effects.

If you are a venture capitalist and you know that if you risk $2 million in a start-up business which may pay back $12 million in a few years, but which may also go to zero if that start-up fails (as many start-ups do), you might be willing to risk that $2 million if you get to keep 85% of the gain (even though there is a risk that there will be a total loss). But if the government tells you that they will tax the gain at 50% (instead of 15%) you may calculate that it is no longer worth risking the total loss of $2 million for the possibility of making only $4 million (after taxes) instead of $8.5 million. In that case, you may not fund the entrepreneur at all, and a business will not form that (under a less onerous tax rate) might have blossomed and added great value (and many jobs) to the world.

Changes in tax rates cause immediate changes in the decisions of those who are allocating large amounts of capital for the formation of new businesses and the expansion of existing businesses. In fact, even the prospect of taxes rising within two or three years will have a big impact on the allocation of capital right now -- in the example above, that venture capitalist may very well have to wait at least two years before any tangible results come from his investment, so he is making his calculation based on his assessment of the future tax rates that will hit his potential capital gains. The prospect of higher tax rates in the future will have a big impact on the very important allocations of large amounts of capital today. These large allocations of capital, the productionist or supply-sider argues, are the engines which actually drive the economy.

Giving every individual taxpayer $800 is not going to create any new businesses (except in the highly unlikely event that 10,000 of those rebate-holders decide to band together and form a venture fund with their rebate checks and fund a couple start-up companies).

Today's remarks on Capitol Hill were particularly dismaying for a number of reasons. First, many of the members of the House Budget Committee displayed a complete disdain for the impact of tax rate cuts -- one lawmaker even suggested that the rate cuts of 2003 would cost the government trillions of dollars (when in fact, the rate cuts resulted in tax revenue increases, due to their salutary effect on the economy).

Even worse, that lawmaker was able to get Ben Bernanke to repeat after him that "tax cuts generally don't pay for themselves" -- causing listeners to the televised remarks to wonder if Mr. Bernanke is a demand-sider, although in defense of Mr. Bernanke it seemed that the Congressman was "leading the witness." It was clearly a shameless display of grandstanding to get a soundbite, as the lawmaker himself admitted at one point when he reminded the Chairman that many news agencies would pick up his comments.

Finally, the most embarrassing display of the day's proceedings came when Representative Marcy Kaptur (D-Ohio), who has been on the House Budget committee for an entire year as of tomorrow, confused the Chairman of the Federal Reserve with Treasury Secretary Hank Paulson. She obviously had no idea of Bernanke's background as an academic, which is simply astounding.

It's hard to blame the markets for reacting in a negative way today to the various displays of economic ignorance coming out of the House Budget Committee, a government body with some degree of power to directly impact the economy.

For later posts related to this same subject, see also:

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  1. Negativity in the markets is a factor in its infancy compared to what it will be if the tax cuts are not made permanent.

  2. How do these law makers come up with Economic solutions when they, not all, has a minimal understanding of the effects of taxation on either the supply or demand side. Lack of research of the head of FRB by the Law maker makes me wonder if they do their research on the issues that matter or they follow the precedence like in our courts. Both arguments on either end can stand, but what matters is the impact on the economy of the tax rate cuts vs the rebates. The rebates, in my opinion, will NOT stimulate the economy itself. We need more that tax rebates.