In his classic 1992 book about the Ronald Reagan 1980s (and so much more), The Seven Fat Years, Robert Bartley described the great Arthur Laffer describing the universality of credit. It goes like this:
“Laffer would draw a tiny black box in the corner of a sheet of paper. ‘This is M-1,’ currency and checking deposits. A bigger box was M-2, including savings deposits. Still bigger ones included money-market funds, then various credit lines. Finally, the whole page was filled with a box called ‘unutilized trade credit’ – that is, whatever you can charge on the credit cards in your pocket. Do you really think, he asked, this little box controls all of the others? The money supply, he insisted, was ‘demand determined.’”
Bartley’s description of Laffer properly explaining money discredits just about all monetary beliefs in modern times. Lucky enough to have met Dr. Laffer a few times over the years, I’ve always told him I learned more from his writings on monetary policy than tax. And his tax writings taught me an enormous amount.
Thinking about the utterances of Laffer about money during the legendary gatherings at Michael 1, he quite simply nailed it. Laffer showed what’s true, that money is a consequence of production. It’s “demand determined” precisely because it’s production determined. It’s a reminder for the monetary mystics of today (including many self-proclaimed supply siders) that there’s no such thing as “tight” money, not to mention that the Fed’s monetary machinations could in no way result in “tight credit” without the assent of the actual marketplace. The Fed is a follower, which is a line I’m near certain I lifted from Laffer himself.
Credit is borderless. If you’re productive, the money exchangeable for resources will find you. Always. The Fed could announce next Tuesday that it was exiting the money game altogether, and there would be replacements for the dollar on Wednesday; if not sooner. We seek “money” for what it can be exchanged for, which means that as long as there’s production, there will always be exchange mediums moving production’s surplus to its highest use.
All of this and much more came to mind while reading supply-side historian nonpareil Brian Domitrovic’s thoroughly excellent new book, The Emergence of Arthur Laffer: The Foundations of Supply-Side Economics in Chicago and Washington, 1966-1976. The “Laffer of the time before he met Reagan is the subject of this book.” After which, monetary policy is the primary subject. Though Laffer is most known for tax policy today, currency policy was his main focus in the early years. Domitrovic notes that Laffer’s early work “at most tangentially referred to taxation.”
What’s fascinating about the time in question is how rapidly the monetary discussion changed. Soon after completing his studies toward an economics PhD. at Stanford, Laffer took a job as a professor at the University of Chicago’s business school. By 1969 he was awarded tenure. This is notable given his views on currency policy. Laffer was of the view that “the prevailing global arrangement of major currencies fixed at rates of exchange to the dollar, and the dollar itself to gold, was serving the needs of the world economy well.” A believer in money as a measure meant to facilitate the exchange of actual wealth, Laffer’s beliefs didn’t diminish him in the economics profession. He was already a contributor to the most prestigious economics journals (including American Economic Review), and clearly on the way to a career at the top of economic academia.
Then things changed. In Domitrovic’s words, the U.S. “traded winning for losing.” The severance of the dollar’s anchor to gold began in 1971 in “temporary” fashion, and then became official in 1973.
While a belief in fixed exchange rates had a conventional quality to it in the mid-20th century (Domitrovic cites a 1945 poll showing 90% of economists in favor of Bretton Woods), by the 1970s defined money brought its rare supporters “crank” reputations. Milton Friedman didn’t share Laffer’s views about money, he believed in the absence of policy that was floating exchange rates, but as he noted in a 1972 speech, “I was almost bowled over” when the head of the IMF made plain how necessary “greater flexibility in exchange rates” was, a view of money that was “almost unheard of two years ago.” The fixed exchange rates that Laffer supported in the ‘60s, that monetary eminences eagerly sought in 1944 (Bretton Woods) as a way of avoiding the economic errors of the 1930s yet again, were suddenly – and rather haughtily – dismissed by the early 1970s.
Laffer’s reputation suffered in the academic world as a result. As Domitrovic puts it, “the profession of academic economics all but expectorated him from its ranks,” along with his fellow U of Chicago professor, Robert Mundell. The embrace of floating exchange rates among academic economists very rapidly had a monolithic quality to it, but Laffer and Mundell stuck to their guns. They knew. So does Laffer’s historian in Domitrovic: “Now currencies ‘floated,’ having a new value at every moment in the marketplace and inconvertible in gold or anything else.”
Put another way, money was no longer money. Missed by the academic crowd not Laffer and Mundell was that no one bought, sold, loaned or borrowed money; instead money signaled the exchange of products for products, or the exchange of products now for greater access to products down the line. But with money floating, its sole purpose as the mover of resources to their highest use was suddenly impaired. With money no longer trusted, the trade that enabled economy-enhancing specialization wouldn’t be as regular. Worse, the investment that powers all economic growth would logically shrink in amount due to the aforementioned lack of trust in money. Never forget that when investors put money to work, they’re buying future income streams and returns in dollars, pounds, Swiss francs, etc. But with the dollar no longer a stable measure, and with the severance of the dollar’s link to gold by the Nixon administration a loudly implicit dollar devaluation, there would be a brutal tax on investment going forward.
Again, Laffer and Mundell knew all this. They supported a currency arrangement that placed the dollar at the center of the world, and that had logically coincided with so much economic growth and recovery (think Japan and Germany) from near-total devastation wrought by war. Stable money personifies progress precisely because it fosters the most trade and investment that make progress possible. Suddenly money would be unstable.
Again, they knew the chaos that would ensue when the world’s standard in the dollar was suddenly anything but. As Domitrovic explains it, “There had been no crisis brewing in the economy, Laffer and Mundell said. Rather, the economy met a fate that the establishment of professional economics had engineered for it by means of maladroit policy.” Yes. The floating dollar was logically the crisis simply because money with indeterminate value quite simply isn’t.
What’s staggering about all this is that economists could so monolithically believe that floating money would be an economic enhancement. Economic historians will marvel at their shocking lack of common sense. Or will they? Let’s never forget that economists similarly believe in near-monolithic fashion that economic growth causes inflation, that government spending made possible by economic growth actually boosts it, and that the wealth destruction, maiming and killing that is war has a growth upside. Thank goodness the profession “expectorated” Laffer and Mundell. Academia’s loss was our gain.
Indeed, thanks to their being pushed out of allegedly polite academic circles (Domitrovic points out that this would have pleased Laffer’s well-bred mother who thought the Chicago crowd beneath her son), Laffer and Mundell somewhat jettisoned the economic journals read by very few in favor of the Wall Street Journal’s legendary editorial page. What vision Robert Bartley (editorial page editor) and Jude Wanniski had. Call them “thought entrepreneurs.” They saw the genius in Laffer and Mundell that a confused economics profession seemingly didn’t.
Writing much more for the public, Laffer and Mundell relayed the importance of stable money and low taxes to a lay readership that had been brought up on vastly overrated and non-economic notions like “balanced budgets” (Domitrovic quotes Laffer as telling Bartley that “It’s not government borrowing that crowds out the private sector, but government spending.”), impossibilities like “trade deficits,” not to mention how the two economists never strayed from the classical, Adam Smith view that money quite simply is; as in it’s a consequence of production that no reasonable thinker would ever worry about. Really, to read economic thought in the ‘70s or today is to marvel at just how confused it was, and is. Were Adam Smith alive, he would look with great incredulity at statistics revealing $7 trillion of daily currency trading. Wait, what? Currency trading? Who would trade what solely exists to move consumable goods?
Needless to say, the commitment to good money began to wither in the late ‘60s. One case used to force the dollar away from its peg was related to the U.S. supply of gold at Ft. Knox. Domitrovic references Robert Triffin, a vastly overrated gold opponent at the time, as saying that the “enormity of foreign dollar holdings” made severing the dollar’s gold link inevitable. Which was total nonsense. Though gold defined the dollar, the dollar liquefied global trade and investment. If the U.S. maintained its commitment to the dollar’s price at 1/35th of a gold ounce, there would have been vanishingly few redemptions. Yet even the latter kind of misses the point.
The reality is that any kind of gold or gold exchange standard logically requires no gold holdings. Precisely because the metal is abundantly traded in the marketplace, a U.S. wholly bereft of gold stock could easily go into the market to handle any and all dollar redemptions for the metal. Triffin was way off.
Furthermore, Domitrovic alerts readers to something not known to this reader beforehand: the U.S.’s gold stock was very much a modern concept. And not a happy one. It turns out the Ft. Knox stash of gold was a consequence of FDR’s decision to confiscate gold from the U.S. citizenry in 1934. In other words, the U.S. had been on a gold standard for roughly 150 years without substantial gold holdings. If it worked as it did before 1934, there was no basis for the suggestion that a depleted gold stock would render the standard unworkable in more modern times.
So why the departure from the good money that Laffer and very few other reasonable people supported? The view here is that the silly arguments against currency-price stability made by Triffin, Friedman, Richard Nixon, John Connally et al were really beside the point. The greater, sadder truth is that devaluations are as old as money is. As long as money has existed, economic types have been trying to engineer the proverbial foot, minute, or degree of heat with an eye on re-writing reality. Free market hero Friedman wanted government to plan so-called “money supply,” which was Friedman saying government would plan production. Triffin just didn’t understand the gold standard, or money in the way that a self-proclaimed expert should. Nixon was a foreign policy type who felt a weak dollar would trick foreigners into buying “cheaper” American goods. He misunderstood the essential truth long uttered by Mundell that the only closed economy is the world economy, and production of anything is global in scope. Connally? Oh please. He was most famous for saying he didn’t understand comparative advantage, but that even if he did, he wouldn’t agree with it!
A dollar defined in gold was too good for money given a long history of something-for-nothing leaders devaluing it. History arguably killed off the Bretton Woods agreement far more than Nixon et al did.
Still, the academic dumbing down of economics and money once again meant that there was “no warm high place” for Laffer and Mundell in the economics establishment. So they wrote for the public instead. Laffer’s first piece for the Wall Street Journal was published in January of 1973. It was titled “Do Devaluations Really Help Trade?” As the economics crowd fell for the abjectly stupid narrative that countries could devalue their way to prosperity, Laffer continued to write common sense. That Laffer remained sane and brilliant brought up a question maybe only answered indirectly in the book: though Laffer was and is an empirical economic thinker, did his Stanford education shape his thinking on matters of money, taxation and growth more broadly? Domitrovic spends time on a socialist professor at Stanford (Paul Baran) whose disdain for “surplus” helped shape some of Laffer’s thinking, the late Ronald McKinnon (a supporter of fixed exchange rates throughout his own career) was similarly close to Laffer at Stanford, but the guess here is that he would have happened upon his views regardless of the PhD. credential.
And then there was Laffer’s time as chief economist at President Nixon’s OMB. This has long been significant mainly because a focus on so-called “money supply” had very much begun to captivate the economics establishment in concert with Laffer’s arrival in Washington. The bet here is that if Friedman were alive today, that he would be embarrassed to be associated with the focus. Indeed, through no fault of his own the economist in Laffer was tasked with projecting the direction of Nixon’s economy. He, my old H.C. Wainwright boss David Ranson, and others inside OMB projected Gross National Product for 1971 of 1065, or 1065 billion.
Domitrovic reports in detail the ridicule Laffer suffered for projections that turned out to be true. Additionally, the projections naturally led to all manner of debate inside the Nixon administration about how much money growth would be required to reach “1065,” thus the view here that Friedman would be embarrassed by the central planning at the core of monetarism. Domitrovic’s reporting on the matter was more about the vicious critiques of Laffer by charitably substandard thinkers like Paul Samuelson, but the desire here was for more from Laffer about how dopey the economic discussion around him had become. That is so because Laffer yet again never wavered from his belief that production was and is the instigator of money, as opposed to money instigating. In that case, how frustrating it must have been to create projections for a president and minions of the president so hopelessly enthralled by the very central planning that was so thoroughly wrecking so much of the non-free world at the same time.
Notable about this is that post Nixon, Laffer advised subsequent Republican administrations as opposed to working within them. The idealist in me wants to think he did so in order to avoid ever having to pretend 2+2 equals 1,000 ever again.
Indeed, Laffer’s too good for the economics of Washington, and the profession more broadly. Toward this great book’s end, Domitrovic writes of how the always-generous Laffer maintained cordial relations with Friedman despite differing views on money, and even looked for ways to excuse Friedman’s monetarism (realistically Keynesianism turned inside out) as a needed “club to beat down Keynesianism.” Laffer knew the so-called “money supply” that captivated Friedman was a consequence of economic activity, but he swam above the pettiness that defined and defines the profession.
How Arthur Laffer dealt with Milton Friedman on a monetary matter of utmost importance says so much about his genius as a thinker (he knew and knows money in the way that few do, including countless supply siders), but it also says it all about him as a person. He’s kind and generous in addition to being brilliant. Read The Emergence of Arthur Laffer to see why.
Reprinted from RealClearMarkets
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