The Liberty Interview With Dr. Arthur B. Laffer
Interview Date: April 5, 2023

Interviewer: Hanako Cho

 

Loose Monetary and Fiscal Policies Have Increased the Financial Pressures

Dr. Laffer: We have had now, I think, since 2008, effectively a zero-interest-rate policy by the Federal Reserve. Whenever bond prices start to fall, i.e., interest rates start to rise, they step in, and they buy those bonds. They hold them on their balance sheet, and they bid the price of the bonds up so that interest rates on those bonds go down.

The Fed has been doing that now for 15 years, locking in low interest rates. Now, they’ve been doing it a lot in the last four or five years. They have bought almost every single long-term bond in the U.S., so in the marketplace for government securities, the proportion of bonds that are long-term, let’s say 10 years or more, is very, very small.

A lot of those bonds are required by law for pension funds to hold so they match liabilities with assets and never get out of kilter. There is a lot of ERISA regulations requiring pension funds to hold long-term government bonds to match the liabilities. This is the backdrop of the Federal Reserve policy.

We also have, since 2008, a very loose fiscal policy. You’ve seen all the stimulus spending in 2008, 2009. First, it was the Bush administration that had spent an extra $1 trillion on stimulus. And then you had the eight years of Obama with very loose fiscal policy. Then you had Trump come in, and there was a two-year window of reprieve, not a massive window, but two years. You had pretty good fiscal policy and deregulation. You had the tax cuts. You had other good stuff happening in there. Then, we had Covid-19 hit and Trump went crazy. He spent $3.5 trillion. That’s huge stimulus spending. Biden came in and did it as well. We’ve had this long period, from 2008 to 2023, of what’s called ‘fiscal stimulus,’ extraordinarily loose fiscal stimulus. ‘Fiscal crush’ is what it really is. That’s been the fiscal policy.

The regulatory policy has been very stringent as well. And then we have a very loose monetary policy. Together, that is what led to a lot of the financial pressures.

 

The Story of the Boiler Room

Dr. Laffer: Now, let me reiterate this fun story. There was a climatologist in the 1960s. In the 1960s and ‘70s, I was very well known. I did a lot of speaking engagements all over the country, all over the world. On one occasion, there was this person named Iben Browning. I have no idea who the person is. I heard him speak twice. He had this example that I think is very apropos of the current time.

‘If you take a boiler in the boiler room, if you turn the heat all the way on, it’s full heat. And you take all of the safety valves on that boiler and turn them off, all right? Then you take a little brass tap hammer. You come into the boiler room every 15 minutes and turn the heat on full blast and by turning off the safety valves, you have guaranteed that that boiler will explode. By going in there every 15 minutes and going on the side of the boiler, you’re guaranteed to be there when it happens. Your tapping will be the catalyst that will cause the explosion. It is not your tapping on the hammer on the boiler that causes the boiler to explode. But that is the catalyst that makes it happen that second.’

We have the boilers all turned on with hugely deficit fiscal policy. You look at the national debt as a share of GDP. It’s gone way, way [high]. If you look at the monetary policy, it’s been equally bad. If you look at the Fed’s balance sheet, which is the key to Fed monetary policy, there’s been a huge expansion. They were going to try to lower the assets on the balance sheet. Then along comes Silicon Valley Bank. As the days go on, the pressure in the boiler gets higher and higher and higher. All right?

 

The Backdrop of Silicon Valley Bank’s Crisis

Dr. Laffer: I don’t know how new it is, but Silicon Valley Bank is a new bank and it’s grown very, very rapidly. It is a bank that has a lot of large clients. A lot of [the SVB clients] have deposits that are far over the FDIC guaranteed limit of $250,000, so their depositors are all hot money. They are chasing returns. Their loans, to the extent that they’re not government bonds, are basically to venture capitalist firms that have portfolio companies that are, by their very nature, risky. But they’re very high return on average over a long period of time.

Silicon Valley Bank, with its steep climb in assets, steep growth path, found it very hard to make money in a zero-interest-rate world. So, they moved their maturity level out of their assets, holding government bonds. Now, these are the ones that are authorized by the Federal Reserve as being the secure bonds, but they move the maturity out to get some yield. They’ve got longer and longer maturity bonds in their assets. And of course, all of their liabilities are all very short-term. That is the backdrop there.

Now, they are regulated very carefully by the San Francisco Fed: the Federal Reserve Bank of San Francisco. The president of the Silicon Valley Bank is also a member of the board of directors of the San Francisco Federal Reserve. There are a lot of relationships going on there, but the Federal Reserve Bank of San Francisco is the entity that regulates, reviews and supervises Silicon Valley Bank. They fall within that Federal Reserve district of San Francisco. They have the regulators in there all the time looking at it.

My view of the regulators is that they did their jobs correctly. This is not a factually-based comment I’m making to you, Hanako. This is my view. Regulators are not allowed a lot of discretion. They regulate, and they have a checklist of what they’re supposed to look for. They look at all of the assets of the bank by maturity, by risk value. They may have up to 50 or 60 different categories of assets, depending upon how mature they are, how risk[y] they are, all of these different characteristics. They’re required to check each one of those boxes. They look at the proportion of the portfolio in each one of these assets, and they are required to make a statistical, arithmetic assessment of the riskiness of this portfolio. They then look at all the liabilities of Silicon Valley Bank and all the banks to see who the liabilities are to, how much of them are insured, how much are not insured, how fast, how long they’ve been in there, what the interest rates the banks pay the depositors are. They have a comprehensive checklist for all the assets and liabilities of each and every bank they supervise in the system. They supervise them very frequently, Hanako. This is not something that’s done once every five years. This is done all the time. In fact, in some of these banks, I would be surprised if they didn’t have a full-time person at the bank checking on the assets on a daily basis almost.

Now, how do they check on these balance sheets? They do a spread risk assessment. They take the current interest rate, let’s say, the current 10-year bond yield, and they say, ‘What would happen to the balance sheet of this bank if interest rates fell by 4%? What would happen to the balance sheet of this bank if interest rates rose by 4%?’ They use a spread sensitivity to test how risky the bank is for changes in interest rates. When they go up 4%, they look at what would happen to all the assets and liabilities by category. They would then assess the riskiness of the banks’ portfolios.

I have a very hard time believing that these supervisors did not do their jobs correctly. I think they followed the rules exactly correctly. They should have and would have known how risky this bank was, and how sensitive it would have been, to rising interest rates. It’s like thinking a policeman doesn’t know [daily routines]. This is a routine job. They do it all the time with banks. It is a checklist process. It’s a very, very important process that should not be subject to human error. And I don’t believe it is. It’s a very mechanical process that these people would have oversight of the process. That’s my view of the world. I’m almost positive it is true.

Let’s say the Fed’s supervisory committee is looking at Silicon Valley Bank and they find that their assets are very long maturity, their liabilities are very short maturity, they’ve been paying high interest rates to attract depositors and these depositors are hot money depositors – in other words, they aren’t loyal to the bank at all. They’re just there for the interest. They can leave in one minute and be back the next minute.

If they look at all of these situations, they should have been, and I believe they were, completely aware of what the sensitivity of Silicon Valley Bank was to any type of interest rate changes.

Now, they should have had a procedure for taking that information into the Federal Reserve Bank of San Francisco, communicating that risk profile to the officials at the San Francisco Bank. It should’ve gone all the way up to the president of the bank. The president of the San Francisco Bank should have been totally aware of the risk, therefore, and should’ve been alerted, ‘Beep, beep, beep. There’s a problem here.’ I think that probably happened. That’s my assessment of what happened.

 

Marketplace Activities Behind the SVB Failure: ‘Not a Regulatory Problem nor Communication Problem’

Dr. Laffer: Let me now go through with what then occurred in the marketplace. With the Fed reducing its balance sheet, the Fed has been selling bonds in the market. This means the Fed has been taking monetary base out of the system.

This is what they call ‘tightening monetary policy.’ It’s really not, but that’s what they call it. It’s tightening monetary policy because there’s an inflation problem. They’ve been tightening this monetary policy for quite some time, very slowly. They’ve basically let assets run off the portfolio. They’ve reduced it from about $8.8 trillion down to $8.4 trillion over a pattern of maybe 18 months. Of course, inflation has been high, and with them not buying bonds but actually selling bonds, interest rates have been rising in that time period. Interest rates rose to where the 10-year bond, got up to something like 4.25% or 4.5% at its peak.

That was a perfect example of the test stress on Silicon Valley Bank. Now, if you look at Silicon Valley Bank with a 10-year bond yield of, say, four-plus percent and they bought these assets when interest rates were 1.5%, their portfolio’s average yield-to-maturity would be probably 1.5%, maybe a little higher or lower, but not much more than that. These are all government bonds so they’re perfectly secure. If you took those bonds when they yield 4.5%, the price of the bonds will fall very sharply to let the interest rates, the 1.5% bonds, have a yield now at four-plus percent. When you look at their balance sheet valued at a cost basis, not mark-to-market, it looks fine. But if you look at the balance sheet in the basis of a mark-to-market, what would that bond sell for today? There is a huge unrealized capital of loss in those balance sheets.

Then you go and look at their liabilities. The liabilities are all to very hot-money depositors who are seeking out returns. That’s all they do. They ask, ‘Where can I get a higher return?’ and move the money quickly. A large percentage of Silicon Valley Bank deposits are not insured.

You had a very high increase in the cash flow cost of Silicon Valley Bank keeping depositors. And you’ve had a very large capital loss on the balance sheets assets of Silicon Valley Bank. There was a red alarm bell that went off in the system, and there became a group of depositors that said, ‘Wow, this is now a risky bank. We’re going to start withdrawing funds.’ I don’t believe it was a regulatory problem. I don’t think it was a communication problem. Somewhere between here and there, the intensity of the alarm bell was not loud enough for these people to come in and say, ‘Do something now.’

This was the little brass tap hammer going tap, tap, tap. The bomb was set off. Bad monetary policy, bad fiscal policy was turning the flames on full blast, and the other was turning off the safety valves. That was the bad policy. The Silicon Valley Bank specifics was the catalyst that caused the thing to go bang. We had several others happen at the same time. We had Signature Bank. We had Credit Suisse. We had a bunch of other banks. A lot of them were public banks, Zions Bank. Wells Fargo had a little run on it. There were some other banks that did. That is the backdrop of all of these problems.

 

‘The Fed Caused a Temporary Delay in the Problem’ and Guarantees ‘Bigger Explosion’ in the Future

Cho: As you said, the Fed has been squeezing the liquidity for a while now, but this seemed to be offset by the Fed’s new loan program called the Bank Term Funding Program (BTFP) for that the Federal Reserve created nearly $400 billion out of thin air.

Dr. Laffer: That’s the $400 billion that they used to bail out Silicon Valley Bank and those others. It used to be the Treasury-Fed joint lending operation. They’ve changed their name from time to time, but all of these are just the Fed coming in and buying the bonds. They do it by issuing liabilities on themselves. By issuing liabilities on themselves, that is the equivalent to expanding the Fed’s balance sheet, which is very inflationary in the long term.

Let me just say that the Fed, by buying $400 billion worth of government securities, has caused a temporary delay in the problem but has also increased the heat and turned off more of the safety valves. They have guaranteed this is going to be a bigger explosion in the future. We’ve just postponed the bigger crisis going forward. We have not solved any of the intrinsic core problems of the U.S. economy, which are the core problems of the world economy.

This is the balance sheet of the Fed right now. They’ve offset all of the gains they made by liquidating assets.

You do not change the value of the government bonds by buying the bonds, by doing any of this stuff. Those bonds have to be owned by someone. Let’s say if they’re an eight-year, 1.5% yield bond, there is no way that bond disappears. Someone has to hold that bond because that bond, if it’s held, is going to be at a much lower price than it was when it was issued.

Even if Silicon Valley Bank had more time and could’ve sold off some of those bonds to other people, those other people would now hold the losing asset. There is no net reduction in the total risk to the system by allowing them time to roll off the bonds this way or that way or the other way. It doesn’t solve the problem.

The problem is really the government’s fiscal policy and the monetary policy of the system. I hope I’ve made it very clear specifically from beginning to end.

 

The Mechanism Behind the Bank Run

Dr. Laffer: Now the problem, then, starts the run. A bank run is a very strange phenomenon. There have been ones all over the world for the last 1,000 years as long as banks have existed. When you’re a depositor in a bank, you use those funds for transactions purposes. You don’t even think about your checking account. ‘How much do I have in my checking account? Oh, good. I can buy it.’ You don’t think about the checking account denying your check. Once there becomes a risk in your mind, you think, ‘Oh my god. Maybe they won’t give me my money.’ You demand your money as fast as you can. That’s where the run starts.

Now, once one person starts the run, the bank sits there having deposits being withdrawn. They have to pay those depositors in Federal Reserve funds. Their reserves in Federal Reserve funds are not a large percentage of their assets. If you look at their assets and their liabilities, their assets are a lot longer maturity. Their liabilities are a lot shorter maturity. The amount of assets they hold in short-term government deposits at the Fed or, say, six-month notes or whatever it may be, are much less than 100% of the assets. It may be 20% of the assets. So therefore, they’re paying out their depositors out of this liquid portion of their asset portfolio. This liquid portion starts shrinking. They would have to publish their data all the time. Everyone starts getting worried that the bank will not be able to honor its deposits.

Everyone starts pulling their money out of the bank. This is when the monetary authority is supposed to step in and provide a solution to this problem. I’m going to paraphrase what Walter Bagehot of the London Economist in the 19th century said. The actual phrase is so English and so wonderful: ‘In times of crisis, the Central Bank should discount freely. They should provide all the liquidity necessary for these banks to meet all their withdrawals.’ That is exactly what Janet Yellen, Powell and the group did in Washington on that Sunday night. They guaranteed all the deposits of Silicon Valley Bank beyond $250,000. Now, Silicon Valley Bank had a large number of those deposits over $250,000 so it was very neat. But the problem is not solved. The banking relationships out there are not changed because, even though they’ve driven down the long bond yield from 4.4% or what it is to 3.6% and that has alleviated some of the short-term pain, the prospects for inflation are much higher now because of liquidity.

The prospects for inflation are much higher because of the potential weakness in the U.S. economy. We have less production of goods and services and more money. You’re going to get the expectations of higher inflation. With higher inflation, you would expect to see higher interest rates. The Fed has been trying to control interest rates for so long, and very badly. They always say Volcker did it too tightly. Volcker never tried to control interest rates. All he did was follow interest rates. These people are trying to lead interest rates. When interest rates went up, Volcker raised the discount rate to match them. These people changed the discount rate to change market rates. It’s the exact opposite. Volcker used market forces to allow interest rates to determine the proper level. The Fed operated by Powell and these people have tried to control interest rates in the marketplace, which you cannot do. That’s price control. It’s never worked, and that’s what they’ve done. This is the whole background there.

 

The Moral Hazard & the Fed’s Incompetence

Cho: As you mentioned, for SVB, the FDIC bailed out the depositors beyond the $250,000 limit. How should we view the issue of moral hazard in banking, which appears to be the same thing that happened with the 2008 financial crisis?

Dr. Laffer: Here’s the moral hazard. As long as these depositors are chasing interest rates for their deposits, and I do too, by the way, they make an extra yield. By guaranteeing their deposits and allowing them to have an extra yield, you’ve provided an incentive to the bank management to make riskier loans than they otherwise should make because, if something happens to the bank, the deposits will be guaranteed and the Feds will come in. The depositors don’t face the risk of losing capital, and therefore, the bank managers will take on higher risk than they should have. This is what is called the moral hazard.

Everything I’ve just said is true in the sense of technically true. Now, the question is, do these depositors make enough extra interest to make them the equivalent of bondholders and equity holders who should be liable for the losses of the bank? Does this make those depositors put them in the category of bondholders and equity holders? Their additional yield is very, very small, Hanako. I don’t think that difference in yield is sufficiently large to warrant them to bear the actual equity hazard of the bank itself. I think that this does not rise to the occasion of being an equity holder in the bank and therefore should suffer the capital loss.

Now, Bill Isaac, who’s one of my dearest friends for many years, was head of the Federal Deposit Insurance Corporation (FDIC) under Raegan. He was noted for being really, really good. I’ve been on several boards with him. I just talked with him the other day. He argues that they should be liable up to 20% of their deposits, not 80%, and not 100%. This discussion goes back and forth. But this is the big discussion.

This is not the right time to have that discussion. You don’t discuss bankruptcy and what the rules of bankruptcy should be once you’re in bankruptcy court. You should discuss what the bankruptcy rules should be when things are fine. If a bankruptcy occurs, how should we treat it? We should anticipate it. George Shultz used to say that you prepare for a crisis long before the crisis occurs. During the crisis, that is not the time to be thinking about how you should handle the crisis.

I have told you my view of this. Whenever politicians make decisions when they are either panicked or drunk, the consequences are rarely attractive. All these policy decisions, moral hazard, what level of deposit insurance should be appropriate and all of that should be thought of long before the crisis actually occurs so that we can sit in a room calm, collected and talk about it, have our research staffs go out and look at the different things. Do interest sensitivity tests on the bank to see what happens. Look at how all the deposits have been withdrawn. Have there been runs on banks in the past? All of that should be done in a cool, calm, intellectually-collected environment – not in a panic environment. That is the wrong time to make major decisions.

That is unfortunately not what has happened here in the United States. Fed Chairman Powell is not trained, is not experienced to be able to handle these types of truly deep, rare occurrences in the financial circles. He just doesn’t have the experiential base or the academic base to be able to get his arms around the trunk of the tree. The members of the Fed have been selected not because of their expertise but because of their climate-warming love or because they’re woke or something else. Goodness knows what all these are. You have a uniquely incompetent Federal Reserve board to handle these big issues, even in the best of times. And now we are in the worst of times, and they are being put to the test. They honestly don’t know what to do, and they are panicked. When people are panicked, they don’t make good decisions.

When everyone outside is panicked, put your hands over your ears, shut your eyes, and just say, “I’m not listening. I’m not listening. I’m not listening. Tomorrow afternoon, they will not be panicked.” So when people are panicked, do not listen. Just stay tight. This is from an individual bank, from an investor’s portfolio. Some people call it, ‘Do not try to catch a falling knife in the dark. Wait till it lands, and then you can pick it up.’ All of these things are happening right now in real time.

 

The Cascading Effect of the Financial Market Maladjustment to Other Financial Intermediaries

Dr. Laffer: The financial market maladjustment is spreading to other financial intermediaries, mutual savings banks, savings and loans, real estate investment trusts or all sorts of other ones. The whole nature of the financial system of financial intermediaries is that they lend long and borrow short. They are the institutions that allocate savings from savers to investors, and they charge a commission to do that.

They are a very important component of the society to match savers and investors. Savers are depositors and banks. Investors are the bank’s customers. The banks take the deposits, the savings from people, and they allocate them to investors. All the financial intermediaries do exactly that function. For all of these financial intermediates, almost all of them have longer maturity, higher-risk investments, and they have lower maturity, lower-risk depositors. That’s where we are. This issue is spreading to a lot of other banks. It is spreading to financial intermediaries, like real estate investment trusts, etc., and it is spreading to the management of even the best of the banks.

These banks have virtually no risk, but they’re scared. What these big banks have done is they’ve made contractual commitments to people to lend them money so they could then, in turn, lend money to other people. They have given credit to real estate investment trusts for them to have the debt so they could buy a portfolio and therefore arbitrage the returns. These contracts are done not on a minute-by-minute basis. They’re done over six, seven months.

Let’s say you’ve got a big portfolio of houses you want to buy, and you’re a real estate investment trust. You’ve got to raise the capital to be able to buy that portfolio of homes. You negotiate with the owners of that portfolio of homes, and say, ‘What’s the best price I can get?’ Then you’d go to the federal home loan bank and ask, ‘What type of commitments can I get from you from loans from the government?’ Then you go to the big banks and you say, ‘Here is the portfolio I’m thinking of buying. Here’s what I can get from the federal home loan bank board. Here’s what I can get from Fannie Mae, Ginnie Mae. Here are the commitments I have. Can I get a commitment from you?’

They look at it all, the risk and the return, and they say, ‘Yes, we’ll commit to you to X millions of dollars, X-100 million dollars.’ That’s the way the deals are done. There are dealmakers. There are accountants in all of the REITs that handle these processes, all right? Once the deals are done, you sign contracts. All of them close at the same day. You sign the contract with the people who own the portfolio of homes. You sign the contract with the federal home loan bank board. You sign it with Fannie Mae, Ginnie Mae, Housing and Urban Development (HUD). You also do it with, say, JP Morgan as well. You’ve got all of your loans out there, all of your investments out there. You’ve got your own capital in it as well, your own investor’s equity in it as well. And then you close. But you have all of the commitments aligned up ahead of time.

Let’s say JP Morgan says, ‘I know I’ve got a contract with you. I know you’ve got all the terms of the thing done. I know that, but I’m just not going to give you the money.’ What do you do? Now, you have a contract with them. You can enforce that in a court, but that’ll take a couple months or a year. They just say, ‘Sorry, we’re so concerned about the state of the economy that we’re not going to honor our commitments to make these loans.’ Then you see the real estate investment trust: ‘What? I can’t.’ They’ve got a commitment to buy the portfolio. The federal home loan bank board has its commitments, all of these people, and one of the lenders pulls back from the commitment. You can see how this becomes a contagion.

Then what happens, Hanako, is all of these issues that were a great investment from the standpoint of solvency. The return on buying that portfolio of homes was a great deal. You got a great deal. The loans that you took out were sufficiently matured low-interest rates so that the spread there was a very nice profit margin. You had the JP Morgan in there. You had a very profitable loan and a portfolio, which made you, as a real estate investment trust, very solvent. You made a lot of money, you made a great deal. Now your company’s worth more. Now, all of a sudden, they come through and say, ‘I won’t honor my commitment to you.’ What happens then?

All of a sudden, you have a liquidity problem. How do you fill that gap in the loan? That’s number one. How do you do it if you can fill it in? All of a sudden, you’ve changed a wonderful equity investment to make your solvency really, really good to becoming a liquidity problem. You have a liquidity problem morphing into a solvency problem. That is the ultimate problem of this system. Now, it is not solved. It is not solved by the losses you have or the gains someone else has. That will ultimately be true. But it will not be true in the short run.

 

‘You Can’t Have a Capitalist System Without Winners and Losers’

Dr. Laffer: What you used to have happen in these types of circumstances is, there would be a financial crisis and you’d get all these assets repriced. Some guys would go bankrupt. Other people would make money. At the end of the day, when the dust settled and the smoke cleared, you would have all the same assets. The houses would not change. The people wouldn’t change. They’d all still be the same people. All the streets would be the same. All the cars would be the same. All of the markets would clear in five, six months. You’d have all sorts of new people owning the assets and old people having lost the assets. Some people would’ve gone bankrupt. Some people would’ve made money, but everything would settle out. And all of a sudden, you’ve got this new settling out, and the system starts to grow back again with the new risk taken into account. But everything in the economy is the same.

You would’ve had losers, you would’ve had winners. But you’d be back to the same market economy there, and there would be no long-term consequences of the financial crisis.

Now, in steps the Fed. ‘We can’t have these people going bankrupt.’ They support the losers with debt, Silicon Valley Bank. Silicon Valley Bank would not exist today if they had not stepped in. It would be gone. The Fed tries to mitigate the losses in the system by shoring up losers. By doing that, they also hurt winners.

You can’t have a capitalist system without winners and losers, without profits and losses. The whole essence of capitalism is that, if you make a bad decision, I’m very sorry but you made a bad decision. You’re going to lose money. If you make a good decision, congratulations. You’re going to make money. It’s that private decision-making process that allows prices to signal where investments should go, where they should not go, what businesses are successful, which ones are not.

When the government steps in and does not allow winners and losers, they destroy the very essence of the capitalist system.

That is exactly what has been going on. By not allowing the crisis of 2008, 2009, to occur and allow everyone winning and losing, then six months later, starting again with the new profit and loss, we’re continuing on and on. Every time we come to a new situation, we double down. We would have a GDP 20% higher than it is today if we would not have tried to stop all the losses.

 

Bad Government Policies Stave Off the Ultimate Crisis Date

Dr. Laffer: The last thing I’m going to tell you about the system, which is very important for you to understand, is, by allowing the feds to control interest rates for the last 15 years, everyone in the United States has gotten used to zero interest rates. In order to get back to a capitalist, free market, competitive-price-driven model, you have to have a phenomenal collapse in the system because you’ve staved it off and you’ve allowed cars to disappear.

Over 15 years, a car ages. You have all the investments now that are not good investments, investments that were driven by zero interest rates – not by good, high profit. By not clearing the deck, and not starting over again right away, a free-market capitalist economist is now an economist who specializes in investments in a zero-interest rate world of high inflation.

Here, we now sit with a far more fundamental core problem driven by bad government policies for a long time. How do I convince you that I’ve just told you a true story?

In the short run, there is no question. If you want to stop a financial crisis, you should guarantee all deposits. But what will happen if you do that? You’ll just stave off the ultimate crisis date, and you will see the U.S. go into senescence. Senescence is the aging process where you decline.

When you look at this administration, I see no signs of this administration caring at all about any of the issues I’ve described to you. They just don’t care. They’re into it for their old local politics and they aren’t worried about what the consequences of these policies will be. The other side isn’t either, so we will see what happens. It has almost always taken a major catalyst, a crisis, to change the world. Reagan came in with Jimmy Carter when Jimmy Carter imploded.

You’ve got to think about what the dynamic general equilibrium of the world is, how it changed in 2008, how instead of allowing the market to allocate capital in 2008, we subsidized losers. We exploited winners.

 

America and the Rest of the World are in a ‘Long Period of Senescence’

Dr. Laffer: I use a measure for this which is in my draft paper of where the U.S. is in the world and how this has occurred in the last 25 years. My prime measure is, ‘What has happened to the expected real return on a unit of capital over the last 25 years?’

I looked at that unit of capital each and every year and the nominal return on that capital, and then I subtracted out the rate of inflation on that capital to get the real return on a unit of capital. That is the market’s prognosis of what the future is for the U.S. economy.

I took the one-year yield on government securities, the one-year bond, and I took the rate of inflation and the CPI during that year. Then, I subtracted the two. When you subtract the one-year inflation rate from the one-year return on an investment on the government bond, you have what is the real return on a unit of capital.

In 2003, the U.S. developed an instrument called the treasury inflation-protected security. It’s called a TIPS yield. This is the inflation-guaranteed return. At that time, when they developed it, it was a good measure of what I’m trying to get at. The TIPS yield is the expected real return on a unit of capital over the maturity level of that. Two things are difficult with that TIPS yield. Number one, it started in 2003 so we don’t have any back numbers. Number two, it only exists for a 10-year bond.

I find that now, the TIPS yield is consistent with what I’m describing. You take the one-year bond yield. You subtract the one-year rate of inflation for that year. You get the real return on a unit of capital for that year.

If you look at that plot, the real return has been declining dramatically over the last 25 years. There was a huge drop in 2020. It popped back up in 2022 but it’s still well below its trend after that. It popped up, but it didn’t pop up to as high as it was before.

We are in a long period of senescence in the U.S. – my view of the world. Not only is the U.S. in a long view of senescence, but Japan is very much so and so is the EU. The European Union is declining dramatically. Chile, the great country of South America has flipped and is now starting straight south. Russia is clearly in a long period of senescence.

China under Xi has changed all of its policies. It is no longer the go-go economy from 1970 to 1920 to 2020. It’s not that same economy because Xi is putting on regulations, restrictions – what he’s done to Jack Ma and all these other people, all the companies. He’s incorporated them into the communist fold. He’s nationalized a lot of these industries. China is starting out on a long period of senescence as well. Britain has been in senescence as well. I could go on and on. When you look at the world, every one of the major countries of the world is in this tailspin decline right now. But that’s the truth. That’s where we are.

 

Laffer’s Solution: Flat Tax, Spending Restraint, Sound Money, Free Trade, Minimal Regulations, Among Others

Dr. Laffer: It’s all because of the U.S. policies in 2008, 2009. Have I brought this all together to you so you can see the complete structure of the general equilibrium – my assessment of the general equilibrium status of the world economy? Do you see it all brought together?

I’ve tried to bring together my worldview into my macroeconomic general equilibrium view of the US economy on down to the specifics of the monetary policy, the fiscal policy, on down to the specific triggers, the catalysts that are causing that process to collapse.

Now, you ask yourself the question, ‘How can we change it?’ – the question that I always ask myself. You will see in my paper how I’m proposing to all the candidates to start the change. I’ve never ever in my life only described problems, but my job is to sit there and figure out, given this is the problem I’ve described: what is the solution to this problem going forward?

You know what it is, but I’ll say it anyway. It’s low-rate, broad-based flat tax, spending restraint, sound money. We need to reform the monetary system totally, minimal regulations and free trade. We need to have medical transparency. We need to have enterprise zones for the poor and the inner cities that have not shared in our prosperity. We need energy independence – deregulation of the energy sector, totally and completely, in the U.S. We need to privatize U.S. assets as best we can. We need all of these things in the U.S.