The U.S. experienced a period of recession during the 1970s. During that time, Dr. Laffer stood alone to “sell” his idea for supply-side economics to the U.S. presidential administration. The Liberty spoke with Dr. Laffer about how he lived through that period of endurance.

(Interviewer: Hanako Cho)

Four Presidents Who Didn’t Understand Economics Invited the Recession

—We can compare the current coronavirus recession to the recession during the ’70s. You experienced the ’70s recession firsthand. Could you speak on your experience?

Dr. Laffer: It was an extraordinarily deep recession. I was in the White House from 1970 to 1972. I went back to the University of Chicago in late 1972, and stayed on as a consultant to the Secretary of Treasury, then George Shultz, and Bill Simon after him. We went to the White House two days a week from 1972 on through the end of the Ford administration in 1976.

On August 15, 1971, President Nixon suspended the U.S. dollar’s convertibility to gold and the value of the dollar crashed. An international monetary system, known as the Bretton Woods system, collapsed. We devalued the dollar and went on to floating exchange rates.

I wrote an article in the Wall Street Journal called “The Bitter Fruits of Devaluation” which was that we would have hyperinflation after the collapse of the Bretton Woods system. Many economists in the U.S. wrote letters screaming how dumb and silly it was, and said that there would never be inflation in the U.S. like this. And then, as you know, we had double-digit inflation within a year or two.

There was nothing wrong with the U.S. economy until the end of Nixon and the beginning of Gerry Ford (Gerald Ford).

Gerry Ford had his Whip Inflation Now (WIP) program to combat inflation.

In September 1974, I was having dinner with my Yale University classmate and dear friend, Dick Cheney, and Donald Rumsfeld at the W Hotel, which is right next to the Treasury Department. The WSJ journalist Jude Wanniski was also there. I was trying to explain to them how the tax increase that Gerry Ford had been trying to put in, a 5% tax surcharge on corporate tax and income tax for high-income earners, would not provide 5% more tax revenues because it will stop production. People will try to get around the taxes, and, in fact, it might even lose money. That’s when I supposedly drew on that napkin, the famous Laffer curve that Mr. Wanniski introduced later on. I explained that higher taxes will not help the economy, and the concept turned out to be true. Gerry Ford had his WIN, which was a tax increase, and it reminds me of the Japanese government raising the consumption tax. It worsened the economy.

Then, the Watergate crisis occurred, and the Republicans lost everything in 1976. Jimmy Carter was elected President and raised taxes dramatically. We had the National Energy Plan, which made it illegal for you to sell oil and gasoline above the price control level, even though the market prices were much higher. If you’re not allowed to sell your oil at the market price, why would you sell oil? You wouldn’t. This meant that they stopped producing.

Carter said that you had to sell gasoline below the market price to help poor people. Well, what do the gasoline stations do? They rationed it. Therefore, you have lines that would take you four and five hours before you could get half a tank of gas. It was the worst thing in the world that happened, especially for the poor and the minorities who had to work awful jobs far away. These government policies always hurt the poor. And it’s very sad.

I believe these four presidents —Johnson, Nixon, Ford, and Carter— were the four worst presidents in U.S. history. They didn’t understand economics at all. Everything that supply-side economics stood for, these people did the opposite.

I learned supply-side economics in real time back then when not many people agreed with me.

Increasing Taxation Began a Downward Spiral of the Great Depression

—I want to ask you about the 1930s Great Depression in relation to the recession during the ’70s. President Roosevelt responded to the crisis by introducing the New Deal. How do you evaluate that?

The 1920s, just before the Great Depression began in 1929, was called the Roaring ’20s. It was a period of massive tax cuts and increasing prosperity, just enormous prosperity, led by the Democratic President Woodrow Wilson’s tax reduction policies.

President Wilson said in his 1919 State of the Union address that there’s a point in which higher rates of income and profit taxes remove the incentive to new businesses and produce unemployment.

After World War I, high officials looked at top income tax rates over 70% and discussed whether higher income taxes can be destructive for production. There was a consensus that cutting these rates would bring in more revenue, and the highest marginal income tax rate fell from 73% to 24%.

Before the Laffer curve had been presented, the Democratic Party at the time understood that the tax rates had already passed the point of productivity, and that higher taxes would only lower the incentives of the people. The federal government had a budget surplus from the 1920s to the 1930s. The U.S. experienced the greatest period of mass prosperity in its history.

Then, the Great Depression happened. Many people understand that the Great Depression was a crisis of capitalism, but I believe high taxes guided the Great Depression.

In June 1930, we signed the Smoot-Hawley Tariff, which was the largest tax increase on traded products. This caused the collapse in the stock market and the start of a decline in the economy. At the same time, federal tax revenues declined significantly.

What did Herbert Hoover do? When Herbert Hoover raised tax rates, he raised the highest marginal income tax rate in 1932 from 25% to 63%. He increased inheritance taxes and corporate taxes, and put in gift taxes and consumption taxes. I mean, there isn’t a tax he didn’t put in. The Great Depression extended because the government raised taxes in the midst of a declining economy.

In 1933, Roosevelt (FDR) came in as president and made no major change to Hoover’s economic policies other than intensifying them, with the exception of a very small time period.

FDR required Americans to turn in all of their gold in their possession valued over $100 in exchange for $20.67 per ounce. This is essentially a wealth tax.

Once the government confiscated all the gold at $20.67 per ounce, FDR raised the official price of gold to $35 per ounce. All of the gain from this price difference went to the government. Gold
remained at this price until the 1970s.

This process devalued the dollar by almost 40%. Not only were holders of gold deprived of the price appreciation, those who saved the U.S. dollar were deprived of their assets.

During his second presidential term in 1936, FDR raised the top federal individual income tax rate to 79%. States also implemented income taxes, corporate taxes and sales taxes. These simultaneous tax raises in 1933 set stage for 1933 as the worst year of GDP collapse and the Great Depression.

In the 1930s, people weren’t quietly obeying the government. There were tax revolts in every state during the ’30s. Taxpayers were willing to give up public services in return for not paying the cost of government. Tax revolts of the 1970s and 1980s looked small compared to the scale of tax revolts in the ’30s.

If FDR had lowered the top income tax rate, the downward spiral would’ve stopped and there would’ve been a stronger economy. No such policies were made.

The Problem With Keynesian Theory

Let me just say Keynesian theory has one problem. I’ve read through “The General Theory of Employment, Interest and Money of 1936” a number of times, and there is one area that is a critical link to Keynesian theory.

It is true that if the government spends money, those people who get the money will spend more, that will create more jobs and higher incomes, they too will spend more and there will be this cascading effect to the transfer recipients that will increase outward employment and production. To be very technical with you here, the increase in government spending times the multiplier, which is one over one minus the marginal propensity to consume, will equal the total increase in GDP resulting from government spending.

That’s true, but it’s only the partial truth. It’s not the whole truth.

Meanwhile, there are people from whom the government takes the spending. Those people will have less income and spend less. They will reduce employment. The transfer payers will reduce output and the whole system works exactly in reverse from the people from whom the goods are taken. The net income effect is zero.

Let me give you an example using apples.

If the price of apples rise, it is true that apple growers will have higher incomes, be wealthier and spend more. But it’s equally as true that if the price of apples rises, apple consumers will have lower incomes and their wealth will decline by the exact amount as the increase in wealth of the apple growers. These two effects will offset each other over time.

Income effect of government spending or taxes always sums to zero in an economy. Always.

That’s the problem with Keynesian theory. They look at the spending recipients, but what they don’t look at is the spending payers.

There’s another effect here. While the income effects always sum to zero, the substitution effects do not. With higher-priced apples, apple growers will grow more apples. Apple consumers will grow more apples. It’s also true that with higher-priced apples, consumers will also consume less apples. The substitution effects always move in the same direction. The income effects always offset each other, while the substitution effects always accumulate.

Let me give you a story.

In 1974, I was testifying before Senator Gaylord Nelson from Wisconsin who was head of the Senate’s Committee on Finance at the time. I was on the podium there with very famous Keynesian economists: Otto Eckstein, Paul McCracken and Gardner Adley. I was 33 years old at the time and I was to be up there with them.

Gerald Ford’s Whip Inflation Now (WIN), a stimulus spending plan, was being discussed at the time.

Senator Nelson from Wisconsin asked me, ‘What do you mean by the substitution effect?’ And of course, I disagreed with the other three economists completely. I was frustrated that I didn’t know how to word it correctly, and I threw a question so the senator would understand.

I said, ‘Senator, if giving people $600 stimulates the economy, why do you stop there? Why not $6,000? Why not $60,000? Why not $600,000? In fact, if government spending stimulates the economy, why not give everything to everyone who doesn’t work and take everything from everyone who works?’

‘If everyone who works receives nothing, and all those who don’t work receive everything, what do you think happens to the output of the country?’ Senator Nelson looked at me and said, ‘Why, it would go to zero.’ And I said, ‘You got it. You understand supply-side economics.’ As the dollar value increases, there’s a higher impact of government intervention on the economy, such as the pricing structure, and a greater effect on lowering production.

He then asked the other three economists standing on the podium with me, ‘What is wrong with Professor Laffer’s argument?’ The three economists said, ‘Nothing, nothing. Nothing is wrong in the long run if you did it, but in the area we’re talking about it will stimulate,’ which is just wrong. They will say anything that politicians want to hear.