What happens when the reflation bill comes due?

This post is a guest contribution by Paul Kasriel* of The Northern Trust Company.

This was the subtitle to the WSJ’s April 3 lead editorial, “The 2010 Recovery”. The WSJ editorial board wrote: “As we look beyond this year, the bill for this Great Reflation will eventually come due. Coming out of the last steep recession, in 1983, both interest rates and tax rates were coming down. Today, they are both headed up. In 1983, the regulatory state was in retreat. Today, it is expanding across most areas of the economy.”

Yes, eventually there will be reflation. But when? The editorial board used to hold in high regard the wisdom of Milton Friedman, may he rest in peace. But apparently no longer. Friedman taught us that inflation was everywhere and always a monetary phenomenon. That is, sharp accelerations in the broad money supply would be followed by sharp accelerations in the price increases of goods and services.

Judging from the current behavior of the broad (M2) money supply and commercial bank credit creation, the reflation bill will not be due for a long time. Plotted in Chart 4 is the 52-week annualized growth in the M2 money supply and the sum of commercial bank credit and nonfinancial commercial paper outstanding. The M2 money supply is growing at an annualized rate of 1.0% — the slowest rate of growth in years. Not surprisingly then, credit via the commercial banking system and the commercial paper market is showing an annualized contraction 4.9%. The more objective and less partisan editorial board of the WSJ of 25 years ago would know that this current paltry money supply growth and this contraction in bank credit is not the catalyst for reflation anytime soon.

Yes, the recovery of 1983 was characterized by falling bond yields – falling from post-war record highs because of post-war record high inflation (see Chart 5). During this past recession, Treasury bond yields were not far above post-war record lows. Further declines in Treasury bond yields from already very low levels would require that the economy enter a new recession. Is that what the current editors of the WSJ would wish for the U.S. economy?

With regard to tax rates, yes, the top marginal tax rate was coming down – coming down from 70% (see Chart 6). And yes, the top marginal tax rate is likely to rise in 2011, but not from 70% but from 35%. All else the same, an increase in marginal income tax rates does have negative consequences for economic performance. But all else seldom is the same. The economy performed pretty well in the eight years ended 2000 even though the top marginal tax rate was higher in these eight years than it was in the prior eight years. The economy did not perform better because of the increase in the top marginal tax rate. Nevertheless, this increase was not sufficient to derail economic progress. In the eight years ended 2008, the economy performed relatively poorly despite the lower top marginal tax rate. The economy did not under-perform because of the marginal tax rate cut. Nevertheless, the cut in the tax rate was not sufficient to enhance economic performance. The point of all this is that although tax rates matter, they are not all that matters.