In a recent New York Times opinion piece Franco Modigliani and Robert M. Solow, Nobel Prize-winning economists, weighed in with yet another leftist objection to President Bush’s tax cut. The gist of their criticism is that such a “massive, permanent tax cut” will worsen the international economic position of the United States, leading to a vicious cycle of capital flight and depreciation of the dollar. Their argument is based on long-discredited orthodox Keynesian doctrines prevailing in the 1950s and 1960s. The first part of the argument asserts a direct causal connection between the growth of foreign capital invested in a country and the likelihood of currency depreciation. The second part links a reduction in tax rates with a deficit in the nation’s foreign trade balance accompanied by a rise in foreign indebtedness.
During the 1990s Americans increasingly purchased more goods and services from, than they sold to, foreigners. They financed this persistent “current account deficit” by borrowing from foreign lenders and selling assets, like shares of corporate stock and U.S. government bonds, to foreign investors. According to Modigliani and Solow, as this trend continues and persistent U.S. current-account deficits lead to mounting international indebtedness, foreign creditors may eventually refuse to go on financing the ballooning debt, fearing a depreciation of the dollar on foreign exchange markets that would reduce the earnings and capital value of their assets in terms of their domestic currencies.
The very expectation of dollar depreciation could very well spur a “capital flight,” as panicked foreign investors seek to protect their capital by selling off their dollar-denominated assets. The ensuing scramble to convert the dollar proceeds from these asset sales into foreign currencies would precipitate the depreciation, igniting fears of further depreciation and intensifying the flight from the dollar.
As this self-reinforcing process continues and foreign currencies become increasingly expensive in dollar terms, the United States would suffer a stratospheric rise in the prices of imports and of domestic products that use imported inputs. The authors solemnly warn that “if nothing is done to change the current course,” the process may thus culminate in a runaway domestic wage-and-price spiral that can only be suppressed by “higher interest rates,” that is, a tighter monetary policy, that creates a “hard-landing scenario” for the economy.
The fundamental error stems from the authors’ unreconstructed 1950s Keynesianism, which almost completely ignores the driving force of money on the overall economy and particularly on the balance of payments and the exchange rate. Thus there is no reference by the authors to the crucial role of money in fueling any prolonged depreciation process. As Ludwig von Mises first demonstrated in 1912, the fundamental determinant of the exchange rate between two currencies is their relative purchasing powers. For example if the price of a standard personal computer is 100,000 yen in Japan and 1,000 dollars in the United States, then the yen-dollar exchange rate will be driven by the market to 100 yen per dollar.
At this rate, the holder of dollars would pay the same price for a personal computer whether he purchased it here or in Japan. If the Fed inflates the supply of dollars, all other things equal, it creates an excess supply of money and excess demand for personal computers and other consumer goods in the U.S. market, thereby raising overall prices and lowering the purchasing power of the dollar. As a result, at the prevailing exchange rate, it will be cheaper to purchase computers and other goods in Japan than in the United States and the demand for yen will increase relative to the demand for the dollar, causing the dollar to permanently lose value, or “depreciate,” against the yen as well as other foreign currencies that have not been inflated.
Conversely, in the absence of a change in the purchasing power of the dollar vis-à-vis foreign currencies, Mises’s “purchasing power parity theory” implies that any change in the exchange rate will be strictly temporary and self-reversing.
Powerful Market Forces
Contrary to the authors, a net withdrawal of foreign investment funds from the United States therefore cannot bring about a progressive depreciation of the dollar. Thus if foreign investors begin to question the creditworthiness of U.S. debtors or decide to diversify out of dollar investments, this would cause an increase in the supply of dollars offered against the currencies of those nations that are the destination of the capital transfers, temporarily driving down the value of the dollar in terms of these currencies. However, when the transfer process is completed, powerful market forces will quickly drive exchange rates to their long-run equilibrium levels, thus restoring purchasing power parity between the dollar and foreign currencies.
It is true that international capital disinvestment will entail a rise in interest rates in the United States, but it will not cause a long-run—let alone a progressive—decline in the external value of the dollar unless the Fed attempts to offset the increase in interest rates by inflating the money supply.
Modigliani and Solow’s attempt to link tax-cutting to their dreaded “hard-landing scenario” is also based on outmoded Keynesian doctrine—in this case the “absorption approach,” which almost completely abstracts from the fundamentally monetary nature of the foreign-payments balance and the exchange rate. According to this approach, America’s excess of imports implies that it is inexplicably “absorbing” more goods and services than it is currently producing and, therefore, that its total spending on goods and services is greater than its current income. The United States can only finance this excess absorption by increasing its indebtedness to foreigners.
But Modigliani and Solow contend that a tax cut will raise consumption spending almost dollar for dollar, promoting even greater over-absorption, deficits, and foreign indebtedness. Moreover, since this increased consumption spending will likely be occurring in a full-employment economy, it will unleash “inflationary pressures” that will induce the Fed to increase interest rates, thereby reducing investment. Thus, they conclude, the only effect of the Bush tax cut will be “a further expansion of the recent spending spree” on consumption financed by foreign debt and diminished domestic investment.
This part of the argument can be easily disposed of with two considerations. First, even if Americans spend their tax cuts entirely on consumption, there will be no price inflation, for the funds would be spent by the government, the recipients of its transfers, or the owners of redeemed bonds in any case.
Second, the assumption that the tax cut will lead to a dollar-for-dollar increase in consumption is itself erroneous. The tax cut will immediately increase Americans’ current real incomes, lowering the marginal satisfaction from present consumption relative to that of future consumption and inducing them to save and invest a greater proportion of their current incomes in order to increase future consumption. The increased saving will lower interest rates here and reduce or even reverse the net inflows of foreign capital, lessening the accompanying current-account deficits or transforming them into surpluses.
Thus the authors are wrong on all counts.