Thursday, November 29, 2001

Joseph Stiglitz, who recently won the Nobel Prize in economics, is an excellent theoretician. But even the best economic theoreticians ought to occasionally glance at a few economic facts.
Writing in the Nov. 11 Washington Post, Mr. Stiglitz set about criticizing Republican versions of a “fiscal stimulus” plan. He argues that all but the most temporary of tax cuts unlike his own preference for grandiose public works spending and revenue sharing “would harm budgetary prospects, raising medium and long-term interest rates.”
Mr. Stiglitz claims the heretofore obvious power of the Fed to lower interest rates “has been vastly oversold.” That is, he says, because long-term interest rates must rise with smaller budget surpluses or larger deficits.
“In 1993,” he writes, “a plan of tax increases and expenditure cuts led to lower long-term interest rates. It should come as no surprise, then, that the Bush packages, with its tax increases and expenditures increases, would do exactly the opposite.”
Mr. Stiglitz’ memory is playing tricks with him, or at least with us. What really happened in 1993 is that the Fed held the fed funds interest rate down to 3 percent all year. As soon as the Fed stopped doing that, long-term rates rose, too. Long-term rates always move in the same direction as short rates, but never as much.
The Clinton tax increase passed the Senate by 51 to 50 on Aug. 7, 1993. Long-term interest rates did not fall on that news, but instead began to rise within a few months. The 30-year mortgage rate rose from 6.6 percent in November 1993 to more than 8 percent by March 1995. That rise in long-term interest rates after August 1993 did not happen because the Clinton administration reversed course and cut taxes. It happened because the Fed reversed course and pushed the fed funds rate above 6 percent by April 1995.
This year, we replayed that same story in reverse. By May 2000, the budget surplus was at a record high, but the 30-year mortgage rate was 8.5 percent. In recent weeks, the recession has turned the big surplus into a small deficit, yet the mortgage rate dropped to 6.5 percent. That dramatic decline in long-term interest rates did not happen because the Bush administration reversed course and raised taxes. It happened because the Fed reversed course and pushed the fed funds rate down to 2 percent. Long-term rates, like short-term rates, have nothing to do with budget deficits and everything to do with the Fed, inflation and real growth.
Mr. Stiglitz says “the Federal Reserve controls the short-term interest rates not the medium and long-term ones that businesses pay when they borrow money to invest, or that consumers pay when they buy a house, which are still far higher than the short-term rate.”
The fact that long-term interest rates are “far higher than the short-term rate” is one of the most reliable indicators of prosperity ahead, just as the opposite (a flat or inverted “yield curve”) is a famous symptom of trouble. Banks borrow at the short-term rate and lend long, so a steep yield curve means a great climate for lending and borrowing.
Mr. Stiglitz somehow predicts that a steep yield curve is “not a good sign.” He must therefore envy the flat yield curve in Japan, where long-term interest rates are barely above 1 percent even for corporations. Once again, however, his budgetary theory of interest rates clashes with obvious facts.
How could Japan’s super-low long-term interest rates even be possible in a country that has long had enormous budget deficits? The answer is that Japan’s long-term interest rates too have nothing to do with government budgets and everything to do with (deflationary) monetary policy.
This budgetary theory of interest rates looks like nothing more than a flimsy excuse veiling another agenda. Mr. Stiglitz actually rejects Republican stimulus plans because they “rely heavily on tax cuts for corporations and upper income individuals” and give “very little money to those who would spend it.”
That same argument was once used to defend the frivolous summer rebates, yet Mr. Stiglitz now complains that “the $300 to $600 checks sent to millions of Americans were put largely into savings accounts.”
In short, corporations and upper individuals apparently save too much, but so do recipients of rebates. “This may all sound like partisan [Democratic] economics,” says Mr. Stiglitz, “but it is just elementary economics.” It does sound partisan, but it also sounds like elementary economic nonsense. Saved money does not vanish from the economy. Savings are recycled to finance business investment, mortgages, auto loans and higher stock prices.
Economic logic and evidence should be used to carefully analyze each specific proposal in every self-described “stimulus package.” But pretending that lower tax rates risks higher long-term interest rates is one claim that cannot possibly be supported with logic or evidence. It is just an elementary economic hoax.

Alan Reynolds is a senior fellow with the Cato Institute.

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