Formula-Controlled Automatic Stabilization Tax Adjustments (FASTA)

Wall Street is now giving a vote of no confidence to Reagonomics. The economy is caught in a complex mess of interlocking vicious circles and policy dilemmas. Control of the federal deficit is clearly a key to their solution. But with present policy tools there is no way to control the deficit precisely or even to know how much deficit would be economically appropriate at any given time.

What is needed is a new policy tool, completely separate from the regular budget process (with its inevitable errors of economic forecasting and spending estimates), which can automatically adjust the current federal deficit to the current needs of the economy, by a formula based on market interest rates. When interest rates are rising (signaling excessive total borrowing), withholding tax receipts would be increased, to reduce federal deficits and borrowing. When interest rates are falling (signaling inadequate total borrowing), withholding tax receipts would be reduced, to increase federal borrowing. An "insignificant" $10 change in each person's tax withheld in one month would change the annual rate of federal deficit by $10 billion.

Stabilizing interest rates in this way, entirely through "fiscal" policy (rather than "monetary" policy) would permit the Federal Reserve to increase the money supply at the rate needed to maintain a stable, non-inflationary rate of real economic growth, without regard to interest rates.

Credible assurance that both money growth and the federal deficit would henceforth be controlled "automatically" by formulas tied precisely to the actual needs of the economy would reduce Wall Street's inflation worries. This would reduce interest rates and the interest cost in the federal deficit. It would also increase business confidence to undertake the longer-run capacity-increasing and productivity-improving investment which is so badly needed.

Interest rates are now at record high levels. The stock market is nosediving. Unemployment is expected to increase for at least the rest of this year, and the Congressional Budget Office estimates it will stay above 6% for at least four more years.

Wall Street apparently believes the Reagan economic program will result in still larger federal deficits, continued high interest rates and continued slow economic growth, which will discourage business investment in additional capacity and productivity-improving new equipment.

But probably more important than any specific forecast is the basic uncertainty. Just last June leading Wall Street economists forecast that interest rates would fall by 2-4% in the next few months. Instead, they rose by almost that same amount. Two years ago, when long-term Treasury bonds were earning 9%, it seemed wildly improbable that they could rise to the present 16%. The dangerous fact is that national economic policy is now caught in a series of interlocking vicious circles and policy dilemmas:

• Interest rates are high because of high federal deficits, continuing high inflation, and general uncertainty regarding national economic policy;

• Federal deficits are high partly because of the high interest rates, partly because of high unemployment (which reduces tax receipts and increases "depression relief" payments);

• Unemployment is high partly because of the high interest rates (which depress business), partly because of inadequate "real" money stock;

• The "real" money stock is inadequate partly because of the continued high rate of inflation;

• Inflation is high partly because of the high interest rates (which add greatly to costs and prices), partly because of low business operating rates (which parallel the high unemployment rate and which cause low productivity).

Each 1% increase in unemployment "automatically" tends to increase the deficit by about $25 billion. The present U.S. unemployment rate is now at least 2% (possibly even 3-5% by European and Japanese standards) above any economically justifiable least $50 billion of the victory cut a "mere" $35 drastic would need to be the equivalent of even a definition of "full" employment. This accounts for at current federal deficit. Yet Reagan's recent budget billion from federal spending. This indicates how the additional cuts in spending programs to achieve 2% reduction in the unemployment rate.

Moreover, each 1% rise in interest rates is estimated to cost the Treasury about $2 billion in interest payments. Thus, a mere 5% reduction in the present record interest rates could cut $10 billion from the federal deficit.

The traditional Keynesian and monetarist economic theories and policies have clearly failed, and the so-called "supply-side" theory has neither empirical support nor theoretical credibility. The Administration's economic "forecasts" and the confused congressional budget debates would be funny if they weren't so tragic. As the "supply-siders" contend, the size of the federal deficit is determined far more by the behavior of the economy than by legislated budget policy. But neither Congress nor the Administration is yet making a serious effort to develop the new policy tools which would make it possible to manage the economy in the same businesslike way that business executives manage their own corporations.

As Wall Street has recently emphasized to both the Reagan Administration and to Congress, the size of the federal deficit (not just the level of federal spending!) is a key factor in how the economy works. Yet traditional economic theories and policies are simply unable to deal with this fact in any credible and systematic way.

One of the main keys to understanding the economic role of the federal budget is to recognize that the effect of federal borrowing is essentially the same as the effect of "private" borrowing by consumers, businesses, state and municipal governments and international borrowers. In technical terms, credit is "fungible." In spite of the apparent diversity, complexity, and institutional "fences" of the credit market, it is basically a single national "pool" into which is poured all of our financial saving and newly created money, and from which all sectors borrow. Thus, the general level of "real" interest rates -- the "real" price of credit after deducting the inflation premium, the business risk premium, and the economic uncertainty premium -- is determined primarily by the relationship of the total demand for credit to the total supply.

Clearly, what is needed is some reliable means by which the amount of federal deficit can be adjusted "automatically" so as to offset any destabilizing changes in private borrowing -- or any economically inappropriate legislated budget relationships-- and thus to keep the total amount of borrowing (federal and private combined) continuously in balance with the total supply of financial saving and the economically appropriate increase in the money supply at a policy-determined but economically appropriate level of interest rates.

The Formula-Automatic Stabilization Tax Adjustment (FASTA) would do just that. It provides for highly flexible, precise, automatic (formula-controlled) adjustments in withholding tax receipts, completely independent of the basic legislated tax rates.

Since most payrolls are now computerized, the needed tax changes can easily be effected by a single instruction to the payroll computer programs after notification by the Treasury of the needed change. Taxpayers whose incomes are not subject to computerized withholding could adjust their payments on a quarterly basis.

Suppose, for example, that when the federal deficit caused by Reagan's legislated tax cut and increased military spending is piled on top of "private" borrowing, the total demand for credit continues to exceed the economy's total supply of credit from financial saving and the economically appropriate amount of new money. This will cause "real" interest rates to remain at levels high enough to prevent economic recovery -- the very recovery which could most effectively reduce the actually-realized deficits. Now suppose that Congress were to enact the FASTA policy tool this fall as its first order of business -- instead of starting another bruising budget battle. The present record high it real" interest rates would automatically trigger a temporary increase in withholding tax receipts large enough to bring total borrowing down to a level consistent with economically sounder interest rates. At the same time, by taking political pressure off the Federal Reserve to increase money growth, this would alleviate Wall Street's fears of continued high inflation due to excessive money.

In fact, the mere enactment of such an effective policy tool would probably reduce Wall Street's longer-run inflation fears so much that only a small tax adjustment would be needed to bring interest rates down. That, in turn, would reduce both federal interest expenditure and the cost-effect of high interest rates on the actual inflation rate.

When disruptive federal deficits could be so easily prevented by FASTA,, it would be the height of fiscal irresponsibility to repeat, in 1981-82, the kind of inflationary excess of federal borrowing which resulted from the 1977 tax cut -- borrowing which was generally recognized as excessive only in hindsight.

In the opposite direction, the behavior of the credit market in 1979-80 provided another good example of how FASTA could have got us off the economic roller-coaster. When the Federal Reserve launched its program of "credit restraint" in March, 1980, the effect on consumer and business borrowing was much greater than expected. With our present financial institutions, "new money" is created only through bank loans and investments. In that situation the Fed could have maintained adequate bank lending and money growth only by permitting interest rates to fall so low as to cause a flight of "hot money" to higher rates abroad, with a resulting unacceptable decline in the dollar exchange rate. Thus, the Fed decided to allow the sharp decline in money growth which caused the recession. If FASTA had been in effect then, it would have induced a temporary cut in withholding tax receipts. That would have caused a temporary increase in federal borrowing enough to offset the excessive decline in consumer credit which was the indirect cause of the recession.

In fact, if FASTA had been in effect even earlier, it would have caused a temporary reduction in federal borrowing in the fall of 1979, which would have prevented the sharp "crisis" run-up of interest rates in early 1980 which finally led to the Fed's credit-restraint policy.

Because the FASTA tax adjustments are automatic and precisely timed, once FASTA gets the economy off the roller coaster, the actual amount of the needed tax adjustments will tend to be quite small -- like the adjustments to a car's steering wheel on a straight road.

1. FASTA would facilitate congressional budget decisions.  FASTA would make possible a much more businesslike approach by allowing the regular budget to be formulated on a "high-employment" basis, with stable, standardized economic assumptions, instead of unreliable and ever-changing "guesstimates" of future economic conditions and their effect on federal spending and receipts.

   In fact, a truly responsible fiscal policy could maintain a continuous balance between "high-employment" expenditures and receipts and rely entirely on FASTA to maintain the economically appropriate level of current federal deficit or surplus.

2. FASTA would facilitate better management of the money supply.  The economically appropriate amount of the "new money" created by Federal Reserve policy usually amounts to only about 10% of the total supply of credit, and, except in wartime and other extreme emergencies, the Fed exercises no direct control over the demand for credit. Therefore, when the Fed tries to control interest rates by "monetary policy" (whether to stabilize international capital flows and the dollar exchange rate or for domestic political reasons), this usually causes economically inappropriate fluctuations in the growth rate of the money stock. FASTA, by stabilizing interest rates through "fiscal policy" rather than "monetary policy", would permit the Fed to manage the money supply solely according to the economy's need for money (checking accounts and currency), rather than its need for credit.

   In fact, this would permit the money supply also to be managed "automatically" by a relatively simple formula which would be fully understandable by Wall Street, by Congress, and by the general public -- rather than by the Fed's present secretive and often arbitrary policy decisions based on supposedly arcane monetary relationships and esoteric financial information.

3. FASTA would facilitate more precise estimation of the currently effective monetary turnover ratio ("velocity").  Fluctuations of money growth and interest rates tend to cause confusing shifts between the public's holdings of money (i.e. checking account and currency transaction balances) and various interest-bearing financial assets. This makes it difficult to determine the public's current need for actual money, in relation to the current level of income and spending. (The Fed has permitted and even encouraged this confusion, and has made inadequate efforts to "track" these changes.) Although this ratio is poorly understood by the general public -- and even by many economists -- it is almost as important as money growth itself in its effect on real economic growth.

4. FASTA would facilitate stabilization of real economic growth.  Since growth of the "real" money stock and the related turnover ratio are the primary independent determinants of the rate of real economic growth, FASTA would make it possible to maintain much more stable economic growth. This would permit businesses to plan further ahead and to put more emphasis on economically productive investments rather than short-run speculative investments and tax shelters.

5. FASTA would facilitate full economic recovery.  The policy tools to ensure stable growth would also make possible a predictable, gradual, noninflationary rate of recovery towards the economy's full-employment productive capacity.

6. FASTA would increase productivity and business investment.  A recovery rate of economic growth would increase overall economic productivity as measured by GNP per man-hour. Since the level of investment by businesses in new and more efficient productive equipment is determined more by the growth of demand for their products -- and their respective operating rates -- than by any special tax incentives, a truly credible program for recovery to the economy's full capacity would tend to increase business investment and industrial productivity.

7. FASTA would alleviate the present savings-and-loan crisis.  Record high interest rates and unpredictable fluctuations of interest rates have caused havoc for many financial institutions. Nothing would ensure the financial health of the thrifts as much as a return to stable low interest rates.

8. FASTA would facilitate sounder economic planning by non-financial businesses, households and governments.  Wildly fluctuating interest rates greatly increase the difficulty of any economic planning -- by businesses and households as well as by governments -- because interest payments are a large part of the costs of most sectors.

9. FASTA would tend to reduce the longer-run level of interest rates.  Market interest rates include a business risk premium and an economic uncertainty premium, as well as an inflation premium (whether this is economically justifiable or largely speculative). FASTA stabilization of interest rates and real economic growth would tend to reduce these premiums. This would reduce the interest cost to borrowers without reducing the net return to investors. The resulting reduction in interest costs would reduce the inflation rate, which would feed back into further reduction in interest rates, thus making a key contribution towards reducing the inflation spiral.

10. FASTA would reduce inflation expectations.  By providing a credible basis for appropriate control of the money supply (2, above) FASTA would make a major contribution towards reducing inflation expectations, and thus the speculative component and risk premiums in interest rates and prices. This would feed back into a lower actual rate of inflation, further helping to reverse the inflation spiral.

11. FASTA would reduce the growth of the federal debt.  It would do this growth of the federal debt. It would do this in several ways:
    1. by reducing interest rates -- which would reduce the Treasury's present $100 billion or so of annual interest payments;

    2. by making possible a faster non-inflationary recovery towards full-employment -- which will increase federal tax receipts and reduce "depression-relief" payments;

    3. since there is a complementary functional relationship between federal and private borrowing, and since a higher "operating rate" of the economy tends to increase private borrowing, with stable fullemployment growth a smaller federal deficit -- and perhaps even an actual surplus -- would be consistent with overall economic balance.

Let's end our disgraceful and dangerous roller-coaster economic performance and unnecessary federal deficits. Let's put our national economic policy "on automatic pilot" with FASTA and stable money growth!