This is not a political commentary, but simply one to emphasise that good investors are never dogmatic. Those who are “disciplined”, but inflexible, have historically suffered long periods of underperformance. Perma-bulls and perma-bears suffer when the market moves against them. Similarly, strict value managers suffer every time the profits cycle decelerates, and growth managers suffer when the cycle accelerates. Flexibility is the key to being a good investor.
Thus, it has been perplexing why some observers continue to criticise the current administration’s government spending strategy for righting the economy, and continue to suggest that tax cuts are the key to growth. These curmudgeons remain a vocal group, yet economic figures are slowly improving and, more importantly, the stock market continues to advance. Could it actually be that the financial markets approve of Washington’s spending pattern?
The recent history of tax cuts’ success is mixed. The Reagan tax cuts in the early-1980s had a definitive positive effect on the economy, whereas the Bush tax cuts of this decade had an extremely muted effect. It is somewhat disingenuous, in my opinion, for one to claim that tax cuts are a cure-all after President Bush’s generally impotent policies. Investors in US stocks during the Reagan period were rewarded, but equity investors during the Bush terms were sorely disappointed.
The beauty of tax cuts is that people choose what to do with their own money. The uncertain part of tax cuts is that people choose what to do with their own money. US policy makers must always act in the best interest of the US, but there is no guarantee that citizens will spend or invest tax cuts wisely, or that they will even invest their tax cuts in the United States. That is why tax cuts must be combined with tight monetary policy.
The Reagan tax cuts were indeed coupled with tight monetary policy courtesy of Paul Volker’s Fed Chairmanship. The Bush tax cuts were coupled with Alan Greenspan and Ben Bernanke’s loose (I have argued irresponsible) monetary policies. The Reagan tax cuts were a success, whereas the Bush tax cuts were impotent.
There are two reasons why tight monetary policies are important for tax cuts to be successful. First, tighter monetary policies lead to a stronger US dollar. The dollar (as measured by the DXY index) was extremely strong during the early-1980s, but has been terribly weak during the past decade.
Again, the beauty of tax cuts is that people choose where to invest their money. The early-1980s strong dollar encouraged investors to invest in the United States. However, this decade’s weak dollar has provided the incentive to invest elsewhere around the world. Money typically flows to markets with stronger currencies in order to protect purchasing power and value. With the weak US dollar, the Bush tax cuts provided funds for US investors to make historic reallocations into non-US assets. This certainly muted the positive impact on the US economy of the Bush administration’s tax cuts, but undoubtedly benefitted non-US economies.
The second reason tax cuts need to be combined with tight monetary policy is tight monetary policy causes more efficient allocation of capital within an economy. The Fed Funds rate is effectively the base “hurdle” rate for investment decisions within the economy. Higher hurdle rates force investors to better determine the worth of an investment relative to its risks. Marginal or speculative projects are less likely to be undertaken when hurdle rates are higher because investors’ expected returns might be lower than the base lending rate. If hurdle rates are artificially low (as I’ve argued they have been for the past decade), then there is little incentive for the markets to efficiently allocate capital because the risks associated with unwise investments is perceived to be low. Such unnaturally low hurdle rates spur unproductive investment and bubbles.
Once more, the beauty of tax cuts is that people choose where to invest their money. Tax cuts under loose monetary policy are more likely to result in inefficient investment (like a housing bubble perhaps?), and thus have reduced, or actually negative, impact on long-term productive growth.
I’m all for tax cuts, but one must be realistic about their limitations. Tax cuts coupled with tighter monetary policy is probably a reasonable recipe for enhancing long-term economic growth. Tax cuts with loose monetary policy is a recipe for funds to flow to unproductive use (i.e., tech or housing bubbles) or to flow outside the US (i.e., China and emerging markets).
As an investor, therefore, I have to applaud the Obama administration’s efforts to spend their way out of this deep recession. It would have been irresponsible to simply cut taxes given the Fed’s now decade-old tradition of loose monetary policies. The horrific state of the US economy demanded directed spending. Of course, one could question whether the administration will wisely pinpoint their spending, but the US markets so far seem appreciative nonetheless.
It is ironic that many proponents of tax cuts believe that Ben Bernanke should be reappointed as Fed Chairman. Bring back Paul Volker and more rational monetary policies, and I’d say you could cut all the taxes you want.
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