Bad Thinking Habit #2:
All or Nothing Thinking

Tax policy is perhaps the most important issue in the coming Presidential election: whether to keep the Bush tax cuts, let them expire, or modify them.  If no action is taken, the tax rates on capital gains and dividends will rise automatically at the end of 2008 while the others will go up at the end of 2010.  Mr. McCain and most Republicans wish to keep the lower rates, and perhaps lower some others.  Mr. Obama and most Democrats apparently wish to allow the reduced rates to expire, especially those on higher income levels.

When the latest tax cuts were enacted in 2003, their sponsors never intended them to be temporary.  A sunset provision was needed to keep the scoring within certain legal limits, but everyone understood that the intention was to renew them.  To allow the cuts to expire is a tax increase, and its merits should be judged on that basis.

Although not often mentioned, the Laffer Curve, which shows the relationship between tax rates and tax revenue, is central to the tax debate.  Republican "supply siders" are the chief advocates of keeping the low rates where they are and possibly lowering other taxes as well.  Supply siders generally believe the Laffer Curve proposition that lower tax rates generate higher tax revenue; so to raise tax rates, or let them rise automatically, would not only hurt taxpayers, but would also, by depressing the economy, actually reduce the tax revenue raised by the government.  This would be especially true of the tax on capital gains and dividends where tax payers have some control over their realization.

The other side of the tax debate believes that the supply-side position is nonsense in general and that its intellectual core, the Laffer Curve, in particular, is a proven failure.  George Bush, the father, once famously labeled the supply side position, "Voodoo Economics."

There appears to be no middle ground in this debate because each side is engaged in "all or nothing thinking."  Laffer Curve predictions either work as advertised, or they don't.  Higher tax rates either lower tax revenue or raise tax revenue.  Each side thinks the other side just doesn't get it.

This great divide might not be so great if more people actually had a look at a Laffer curve such as the one below.  Although it's not clear how steep the slope of the curve should be, it is still rather obvious that whether tax collections rise or fall depends on where we are on the curve.  The higher the existing tax rate, the less revenue is likely to be generated by even higher rates.  At some point, the peak, higher rates will start producing lower revenue.

In a world of all or nothing thinking, it is unfortunate that the Laffer Curve was originally over-hyped.  It was advertised as allowing tax rate cuts to "pay for themselves."  That didn't happen completely, to a large extent because of higher government spending, especially on the military, so the budget deficit grew.  As a result, the critics declared the Laffer Curve a failure.

In a more rational world, the fact that it happened largely, if not completely, would be classified as a success, or, at least, a partial success.  All or nothing standards rarely produce successes of any sort.

Instead of arguing whether tax cuts work (pay for themselves) or not, the question should be to what degree they pay for themselves. How much disincentive is there in the present tax structure, and how can it be reduced?  Surely, even the tax increasers don't have maximum tax revenue as their goal.

All-or-nothing thinking is responsible for other needless irrationalities in the tax debate.  For example, one side says "the rich" are the main beneficiaries of the Bush tax cuts without acknowledging that those same rich still pay most of the taxes collected.  And they never acknowledge that many on the lower end of the income scale pay no income tax at all and that number was increased by the Bush tax cuts.  The Orwellian language used in these debates rose to a new level when the government giveaways in the recent stimulus were called "rebates."  Rebates of what?

Taxes are only one area where all or nothing thinking makes debate and rational policymaking more difficult:

In energy policy, it's said there is no policy because prices have risen, or because we are importing more oil, or because oil companies make too much profit or their executives are paid too much.  There is either the preferred outcome in all respects, or there is no policy.

All or nothing thinking bedevils monetary policy as well.  In the recent credit crunch, at first the Fed just didn't get it.  It should be reducing rates for heavens' sake.  Then, when rates were reduced, the Fed was pushing on a string, and ineffective.  When inflation rose, predictably, why did the Fed let that happen?  They pushed rates too low; now look what's happened to the dollar as a result.  Nowhere in the dialog can you find discussion of trade-offs, balancing objectives, or substantial successes.  Monetary policy either works, or it doesn't.  Apparently it doesn't.  Neither, in the view of the all-or-nothing crowd, does anything else.

"Come on, let's get with the program."

Bad Thinking Habit # 1

Last night I revisited one of my old journals — an activity Randy Travis might call "Digging up Bones: exhuming things better left alone." I came across a page labeled "Bad Thinking Habits." Here are a few examples from my list.  I claim no originality.

*Choice of percentages vs. dollars.  [See my confession below.]

*All-or-nothing thinking.  [Stay tuned.]

*Confusing hindsight with foresight, or hindsight with insight.

*Being a slave to habits.

*Filtering out unwanted conclusions.

*Staying married to earlier positions.  (Being born to a belief; being a victim of history or family.)

*Focusing too much on arbitrary time segments (years, months, weeks) when time is continuous.

*Failing to account for diminishing marginal utility.

*Overgeneralization.

*Overly strong or weak time preference.

*Changing value of time vs. money

*Splitting the difference when inappropriate.

There are more in my list, but you get the idea.  See below for my confession regarding bad thinking habit number one.

Percentages vs. Dollars

I struggle with this type of bad thinking all the time, but my most memorable failure came in Seoul, Korea, in 1998.  I was there for a central banking conference, and one afternoon a couple of us went to a famous shopping district to look for bargains.  I found some beautiful silk ties that cost a fraction of what I was used to paying.  I bought only three, for $7.50 each, as I recall, the only three at that price that appealed to me.

They had more ties that appealed to me, but they were priced higher.  I believe they were $10.  I was torn, but in the end I just couldn't justify paying $10 when just-as-good ties cost only $7.50.  After all, that's a third more — 33.33% more. ("No McTavish was ever lavish." Ogden Nash.)

Needless to say, my perspective changed once I got home where my ties costs many times $10.  I had let percentages blind me to the dollar costs.  Dollars are real; percentages are abstract. From an economist's viewpoint, I'd also used the wrong opportunity cost.

That incident didn't cure me, of course.  Yesterday, I spent considerable time in the grocery story comparing the unit costs on cashews, trail mix, and candy, all of which probably came to about $10.  Perhaps that is an accurate reflection of the current value of my time.  At any rate, I bought an expensive mid-life-crisis sports car last year after giving price considerations about the same amount of time.  I should have listened to Benjamin Franklin's caution about being not being penny wise and pound foolish.

Footnote to the Korean trip:  I returned via Tokyo on Japan Airlines. When I plugged my earphones into the seat outlet, guess what was playing:  Elvis's 1968 Comeback Special.  Is this a great country world, or what!

Here are four interviews I did prior to giving the keynote address at the Las Vegas Money Show on May 12 (click on the titles to watch). 

Bear Wasn't a Bailout

Don't Second Guess Fed

I wrote the following article for Father's Day in 2002.  It was published in the Dallas Morning News on June 12, 2002, and is taken from the "articles" section of http://www.bobmcteer.com/.

"Hey Dad, Look at Me"

Me with my sons circa mid-1960s

"Hey Dad, look at me."  That's what dads are for.  You go to dad when you're right proud of yourself.  "Look, Dad, no hands."  "Hey Dad, I made the team."  "We won the game, Dad."

Recently, on an international trip, I had two firsts.  I sent e-mails from the airport in Zurich, and I plugged my laptop into a power outlet on the airplane.  Even though I was a few years late and way behind the curve in such matters, I felt the urge to tell my dad what I had done.  He is long gone, but he couldn't have related to my accomplishments anyway.  He never would have been part of the New Economy, and he never would have owned a laptop or any of its other toys.  But I could have told him it was a big deal, and he would have believed me.  And he would have been proud of me.  Dads are proud of their sons.  It's part of their job description, and it's what sons strive for.

There are no good substitutes for dads.  All my friends with laptops would not have been impressed.  They've all been there and done that, years ago.  My other friends would have not been impressed either — for opposite reasons.

My dad attended some of my high school basketball games.  He didn't know much about basketball and cared less.  But he was proud of me.  Mostly, he was proud that the bigger guys didn't knock me off my feet.  I wasn't that good, but I held my ground — on my feet.  Dads like that.

Until he died, my biggest dread was that he would die.  I used to dream about it.  They were nightmares.  Now that he's gone, I still dream about him.  In my dreams, he still lives.  And I'm still trying to make him proud.

In an op-ed in the Wall Street Journal on March 8, 2008, reprinted as a blog posting — Valuing the Dollar — I called attention to the fact that any particular exchange rate is rather arbitrary and that changes help some and harm others through no fault of their own.  I said that a good sound business could go under because of the exchange-rate effects off a totally unrelated development.  While I didn't think that was totally original with me, I didn't recall ever reading a discussion of that particular point.

In reading Alan Greenspan's book recently, I was reminded once again that nothing is new under the sun.  I'm embarrassed to admit that I did not recall the term "Dutch disease," which is a label that fits my "original" insight pretty well.

According to Greenspan the term was coined by The Economist in the 1970s "to describe the travails of manufacturers in the Netherlands after the discovery there of natural gas.  Dutch disease strikes when foreign demand for an export drives up the exchange value of the exporting country's currency.  This increase in the currency's value makes the nation's other export products less competitive."

So there! While I was intrigued with the coincidence of finding a name for a phenomenon I was struggling to describe, the term is usually associated with — as was the case with Greenspan — the role of natural resources in economic growth.  As he put it on page 257 of his book,

     "Paradoxically, most analysts conclude that, particularly in developing countries, natural-resource bonanzas tend to reduce rather than enhance living standards." 

In addition to the impact of Dutch disease on other exportable goods or services, there appears to be a stifling of productivity and hard work when wealth is found underground.  It reminds me of Dolly Parton-who else?-who said she was lucky enough to be born poor.

While any movement in the dollar helps some people and industries and hurts others, the consensus is that the combination of winners and losers created by a strong dollar is ideal.  My efforts to remind people of the need to use our temporarily "weak" dollar to reduce our humongous trade deficit and provide stimulus to a weak economy as well as slow the foreign accumulation of dollar assets haven't produced any kudos.  One reason, I believe, is my rookie's mistake in using the term "weak."  Since then, I happened to see Marty Feldstein on TV making similar points to mine, which pleased me greatly since I believe him to be at the top of the profession.  However, he wasn't touting a "weak" dollar; he was describing the advantages just now of a "competitive" dollar.  And, to think, I've read Frank Luntz's excellent book, Words that Work.  Hey, guys, I meant a competitive dollar.

Of course, as I attempted to demonstrate in my blog posting on the Big Mac Index, the dollar is not easily characterized as weak or strong, as competitive or not competitive.  It's weak, and increasingly competitive, against the Euro, but strong against many other currencies, particularly Asian countries.  I guess what I meant was that capital inflows had prevented its depreciation from correcting the trade balance.  I still think it's fortunate that that has changed somewhat recently and that the smaller drag on GDP from the foreign trade sector is keeping us out of recession.  So far!  The correction has begun and the dollar can gradually climb back to its lofty heights on the sounder basis of more balanced trade.

I was a guest host on CNBC's Squawk Box this morning, talking about a range of economic issues including the dollar's decline and the outlook on jobs.  If you missed it, you can view clips from the show by clicking here and here.

I'll be guest host on CNBC's Squawk Box this Friday morning from 7 to 9 AM eastern time.  Tune in if you can.

One reason I enjoyed FOMC meetings so much during my 14 years as a member was that I could always count on learning something new from Alan Greenspan, usually some quirky insight or a creative new take on familiar information.  I miss that, but fortunately I have his book.  I bought it the morning it came out, but I didn't get around to reading it front to back until a book club recently invited me to discuss it.

Under the category of quirky information, which he is famous for, is his revelation, on page 50, that the pop top on beer cans was invented in 1963, which made the transition from steel to aluminum beer cans possible.  I didn't know that.

Unfortunately for the reputation of economists with the general public is that they think the job of economists is forecasting.  That's unfortunate because economists can't forecast very well.  It just can't be done.  Economists know that, and most will admit it, but they are stuck with it, especially if they wish to be employed as an economist outside academia.

Even so, monetary policy, of necessity, has to be based in large part on economic forecasts. The Fed staff can forecast as well as anybody and better than most, but that is faint praise.  They use large sophisticated econometric models, and the chairman, who does higher mathematics for relaxation, enjoyed looking under the hood of those models. Yet, he understood their limitations, mainly that their equations are of necessity based on past relationships which change in unexpected ways since they involve human nature.

Chairman's Greenspan's finest hours, or years, at the Fed, in my opinion, was when he didn't take model's projections of imminent inflation at face value in the second half of the 1990s.  It takes courage for an economist or policymaker to say things are different this time because they usually aren't.  But the sharp rise in productivity growth beginning around 1995 did change everything.  Compared to the forecasts of all the models, including the Fed's, output and employment growth was faster while inflation and the unemployment rate was lower. Business could give wage increases without experiencing increases in unit labor costs. The Fed could allow the economy to run hotter without serious inflationary consequences.  Had the Chairman followed the models, the economy would have missed the benefits of faster real growth for several years.

I said that economists cannot forecast well.  That applied doubly to me since I was not as "quantitative" as most and had to depend on my eyes and ears to figure out what was going on and then — dare I say it — extrapolate into the future.  Most of us are closet extrapolators, although most won't admit it.  Of course, you refine your extrapolation with "straws in the wind" indicating a future slowing or speedup.

I've always been amazed at economists who presumed not only to see around a corner, but to see around more than one corner, as in "the economy will pick up through year-end, then slow for several months, and then take off again stronger than ever."  To me that sounds as silly as what they would say to the waiter after sniffing a wine cork.

There is one exception, I believe, to the inability of forecasters to see around corners.  That is, forecasts based on demographics, such as the long-run forecasts made by Harry Dent.  He has shown convincingly that demographics is destiny.  The way I think of it is you can, with demographic data, see more than one pig going through the python.

The first time I heard Harry Dent speak was some time during the boom times of the late nineties, when I was known, pejoratively in most minds, as a cheerleader for the new paradigm, or new economy.  What thrilled me was that Harry's conclusions on the economy at the time were very similar to my own, but that he reached them in an entirely different way.  I thought that, even if my analysis was wrong, my conclusions could still be right because of demographics.

All this is background for a simple Greenspan insight about forecasting that I just ran across.  On page 48 of his book, he says, "Forecasting is simply a projection of how current imbalances will ultimately resolve."  Somehow, that definition makes forecasting sound easier and more practical.  It made me think of the Herb Stein quote according to which "If something is inevitable, it will happen."  That quote in turn made me think of the huge current account deficit and how it has been inevitable for many years that it would cause the dollar to decline.  Stein's quote probably should be amended to include "sooner or later."

Greenspan's book ends with a forecast that the economy is likely to slow in the next several years from the pace we've been used to in recent years.  That conclusion seems more credible to me because it was based largely on demographics.

You can think of economic growth as growth in the labor force (hours worked) times growth in labor productivity (output per hour worked).  The first factor, labor force growth, is based almost entirely on demographics.  Productivity growth may also have a demographic component, but Greenspan places more emphasis on the limits of our intelligence.  He basically says we aren't smart enough to sustain productivity growth over 2.8 percent over an extended period of time. 

As I pointed out in another posting — The FOMC's Enhanced Transparency Reveals Old Paradigm Pessimism — the FOMC members have a similar negative expectation of growth in the next few years.  Their projections for 2010 growth published last October ranged from 2.2 to 2.7 percent, with a central tendency of 2.5 to 2.6.  As I said before, given that 2010 gives them long enough to get policy right, that's a mighty puny forecast.

It's fortunate, then, that economists really can't forecast.

Someone once said if economics made sense we wouldn't need economists.  It's true that good economics is often counterintuitive.  One example of that is the concept of labor productivity, or output per hour of work.  It turns out that the productivity of labor has more to do with capital than with labor. 

When I was about 10 years old I picked a little cotton for a week or two (that was enough) on Billy Joe Hoppers' farm. The pay was three cents a pound, and, as I recall, my goal was to get 100 pounds in a day and earn $3.00.  I don't recall whether I met that goal, but I do recall being bone tired riding to the cotton gin on top of a load of cotton with a delicious feeling of accomplishment.

In retrospect, Billy Joe was just doing my Dad a favor putting up with me.  The real cotton pickers dragged those nine foot sacks behind them and, as I recall, picked over three hundred pounds in a day, making over $10.00.  The difference between my 100 pounds or less and their 300 pounds or more was a difference in labor productivity based on labor — the skill, experience, strength, and tenacity of the workers themselves.

I'm not sure when it happened, but before long, the mechanical cotton picker arrived in Billy Joe's cotton fields, and a single operator could pick acres of cotton in a day.  That guy had enormous productivity compared to the best of the hand pickers. (He gets credit in the productivity statistics even though the mechanical picker is doing the work.)  That's generally the way it happens.  Huge productivity improvements, often based on new technology, come in chunks; it's not a gradual, linear thing, although smaller improvements come in between the big ones.

My point is that the big changes in what we call labor productivity have more to do with capital than with labor. Construction workers working with picks and shovels may work harder, but they hardly have the productivity of the heavy equipment operator.  Labor productivity rises as labor saving technologies enable fewer and fewer workers to do more and more work — or preside over the work done by capital equipment.  Recall the old joke about the factory of the future:  It has only two workers: a man and a dog.  The man is there to feed the dog; and the dog is there to keep the man from touching the computer.

If economic output just keeps pace with population growth, we may be holding our own, but significant increases in our standard of living come from a growing capital stock available to our labor force.  Growing prosperity involves a growing ratio of capital to labor. Think how the bar code and cash registers with pictures on them made pimply-faced high school kids productive behind the counter.  

To belabor the point, rising wages and incomes of workers depend, ironically, on growth in labor saving capital.  Capital investment depends on saving.  Domestic saving has been inadequate to support domestic investment for years, with the difference made up by the capital inflows that are the flip side of our current account deficit.  

We need to shrink the deficit and increase domestic saving, but that discussion is for another time.  Now, I want to focus on the burden of taxes on domestic saving and investment necessary, not only for our general growth, but for growth in the wages of rank and file workers.  Taxes on capital hurt labor, and a huge threat to worker income is the potential increase in the 15 percent tax rate on capital gains and dividends.  That rate should be lowered or eliminated altogether, but it can easily be demagogued as a tax break for the rich, as can a needed reduction in the 35 percent corporate tax rate.

The irony is that increasing these tax rates is very likely to reduce rather than increase the tax revenues to the government.  The Laffer curve works more readily on capital gains and dividend taxes than on other income because the tax payer has more control over them.

Capital gains tax rate cuts almost always pay for themselves; so raising taxes on them will not only slow capital investment, but will have a negative tax revenue effect.  It boggles the mind to know that and say, nevertheless, that "fairness" demands it.