How will Donald Trump defeat the inflation that was brought on by “Bidenomics”?

（The Liberty: December 2024 Edition）

Interviewer: Hanako Cho

 

Cho: Nobel prize-winning economists have warned that President Trump’s economic policy will cause inflation. Many people believe that his tariff plan will be the main cause of this. What is your take on this?

Dr. Laffer: They are using gravitas to speak with authority in areas where they are not in authority. In Latin, it’s called the “argumentum ad authoritatem,” which means the fallacy of the argument from authority on a topic you don’t know anything about. [These Nobel laureates are] being very political and they are not being professional.

 

Trump Tariffs Will Not Cause Inflation

Dr. Laffer: Inflation is not the problem with tariffs. That’s not the right argument. They really will not raise prices because of the tariffs. It’s because tariffs have three offsetting effects.

Number one, if you put a tax on a product, that will cause the price of the product to rise, but not by the full amount of the tax because there’ll be a smaller supply. So, the tariff will not translate directly into higher prices.

Similarly, when you put a tariff on a foreign product, the quantity of the product coming in will decline and the price of what is brought in will rise. The price will decline in that foreign country because we’re demanding less. The demand for that product abroad goes down. The price of that product sold without a tariff will go down and the tariff will make it go up. The net effect will be a small increase and it’s not 100% of the tariff.

Number two, you should consider the substitution effects of imported products as well. If the price goes up in the U.S., more people will produce that product than they otherwise would have produced it. That, too, will tend to bring the price of that product down.

It’s going to cause the imported prices to be lower, so a 10% tariff will not cause a full 10% increase in the prices of imports. You’re also going to get U.S. supplies responding, which will also bring the price down. Now, how much it brings it down depends on how big the base is, how big the sieve is, whether it’s one little product or they can do all these other products. There’s a lot of things that come in there, but the idea that a 10% tariff causes prices to rise by 10% on imports is silly.

Number three, we have Lerner’s Symmetry Theorem. As I spoke about before (February 2024 edition), putting a tax on imports is the same thing as putting a tax on exports, and exports and imports go down accordingly.

Why do people export goods? A country exports goods because it wants to import goods. It wants to get foreign exchange to buy foreign goods and services. It’s the same as the reason why you work– to earn income and to buy goods and services. If you look at a country’s exports and imports, they move right together all the time.

Therefore, if you put a tax on imports, which is a tariff, that is the same thing as putting a tax on exports.

So, you’ve got three offsets. Number one, foreign producers will reduce the real cost of the prices they sell to us. Number two, U.S. manufacturers will produce more of the product domestically, which will keep the price from rising. Number three, you will find the price of exportable goods going down.

Now, you look at the total picture and you realize that 14% of all U.S. trade is in foreign trade. You’re not going to get 22% inflation by the Trump tariffs. I think [the Nobel laureates] are exaggerating their position dramatically.

Now, do [tariffs] have other problems? Yes, but it’s not inflation. Inflation is not the problem with tariffs.

The problem with tariffs is resource allocation and optimal production, the gains from trade and comparative advantage. The tariffs are a problem in other ways than inflation that those Nobel laureates don’t mention. They are just misusing their authority and status, using their position of gravitas, to play politics. They should never do that, and they should be ashamed of what they did.

 

The Current Fed’s Policy Derives from Demand-Side Economics

Cho: Many people criticize Federal Reserve Chair Jerome Powell for the way he is handling inflation. How do you view the Fed’s policies?

Dr. Laffer: I’m going to go through with you the two views of inflation and how to control inflation.

The two views are the Keynesian, or demand-side economics, versus supply-side or incentive or classical economics, whatever you want to call it. These two battle each other and have been from time immemorial. It comes in tax policy, spending policy and whether government spending stimulates the economy, trade policy and all of these regulations. Also, “money” is just as important where the two theories diverge. It’s really important to see this very clearly.

Under Keynesian economics, you would set interest rates to control monetary policy. In order to lower interest rates, you have to buy bonds in the open market which will push the price of bonds up and it will bring down interest rates. In the course of doing that, the Fed has to buy lots and lots of bonds to bid the price up and to have interest rates be lowered.

Now, if they buy lots and lots of bonds, that means that the Fed’s balance sheet is increasing.

How do they pay for the bonds that they buy in the open market? They create money. They create checks on themselves. From 2008 through 2023, the monetary base of the U.S., which is money that is issued by the central bank, went up dramatically and Fed’s assets also went up from $870 billion to about $9 trillion. There was a tenfold increase in the asset. This led to the erosion of sound money, one of the pillars of prosperity.

And what you saw with Biden was that the inflation came in dramatically at 20% inflation for three-and-a-half years.

 

Let the Market Decide Interest Rates!

Dr. Laffer: What the Fed should do is let interest rates be what they may be. Don’t get in there and control interest rates. You don’t want to change the monetary base. Leave the monetary base exactly the same, and interest rates are solved by demand and supply of bonds.

Now, if per chance interest rates go down, the Fed should follow those interest rates down rather than changing the bond market. The Fed’s interest rates will be a little bit higher than the market rates so banks will not find it worthwhile under normal circumstances to borrow from the Fed. But, the Fed should let its interest rates go and rise with the market. If the market goes up and down, the Fed should go up and down with it. And, it should keep the monetary base so it does not intervene in the marketplace (refer to column).

Powell tries to solve inflation by intervening in the marketplace so when we have inflation, the Fed tries to control interest rates and causes a slowdown in the economy.

But when there is a slowdown in the economy and you reduce the quantity of goods and services, prices would go up rather than go down.

Let’s use apples as an example.

Let’s say the weather was just perfect and apple trees doubled their production. What would happen to the price of apples?

Cho: It would fall.

Dr. Laffer: Now let’s imagine the trees did not do it. If there was a big shortage of apples, what would happen the price of apples?

Cho: Price would go up.

Dr. Laffer: Yes. Now let’s imagine this as goods. Imagine there is a huge increase in the supply of goods and services. What would happen to the price of goods and services? Prices would go down. What would happen if there is a recession or depression and there is a shortage of goods and services? Prices would go up.

Powell is saying that the way you control inflation is by slowing down the economy and reducing the supply of goods and services. But, as you can see from our example of apples, it makes no sense for the Fed to try to control inflation through setting interest rates.

 

What Should the Fed Do?

Cho: What should the Fed do from your perspective?

Dr. Laffer: The Fed should look at the market and say, “Is inflation increasing or is inflation declining? Are prices increasing or are prices falling?” Now, when you look at the marketplace, whether you look at gold or silver, corn, rice, what we know are the spot commodity prices. We have them every single day. When the economy is growing rapidly, spot commodity prices tend to lead the economy. When the economy is falling, those prices tend to fall more rapidly than regular prices. Therefore, the Fed would look at the spot commodity prices and ask themselves the question, “Are those price increases or declines caused by the market? Or are they caused by changes in the expectations of inflation?”

If prices are rising, the Fed should sell bonds in the open market and contract the monetary base, thereby put pressure on inflation from rising. That will slowly but surely bring down the rate of inflation and spot commodity prices. If it goes the other way, if inflation is coming down too rapidly and we have a problem with too much deflation, then you buy bonds in the open market and you expand the monetary base until spot commodity prices stop falling and start rising.

After a long period of time, maybe six months or a year, all prices will adjust to the spot commodity prices and adjust to the monetary base.

This is exactly what Paul Volcker did.

In the 1970s, one of my colleagues, Chuck Cadillac, and I wrote a piece on exactly how Paul Volcker did monetary policy after spending a day with him.

What we found is that there are two very different models.

One is to change the rate of growth of the monetary base, change the rate of ascent or descent of spot commodity prices, and in due course, that will change the rate of inflation. The other model is to set interest rates and let the monetary base change as it will in order to control inflation. As you can see, Paul Volcker was right and Jerome Powell was wrong. It’s just a matter of being a good economist or not.

 

Volcker vs Friedman: Volcker Was Not a Monetarist

Cho: As I understand, Volcker didn’t believe in monetarism that was proposed by Friedman at the time.

Dr. Laffer: Paul Volcker was different from Milton Friedman in that aspect. Volcker tried to control spot commodity prices with the monetary base. If the spot commodity prices are rising too much, he brings down the monetary base. If spot commodity prices are falling too rapidly, he increases the monetary base. That was the monetary policy he approved of. On that subject, Milton Friedman said the monetary base should never be changed. He said, “You should not do anything to control inflation.” That’s where they differed.

Paul Volcker had a “price rule” which was spot commodity prices, and Milton Friedman had a “quantity rule” which was the monetary base. That is very different from the debate today, but I hope I’m clear that the monetary base is a tool that can be used to affect inflation. The way Volcker did it was when inflation was growing too much, he reduced the monetary base. He increased the monetary base when inflation wasn’t growing.

Milton Friedman and Paul Volcker were at exact odds.

In fact, can I tell you a little joke?

If you looked up on my wall, I have a picture of me with Paul Volcker. He’s very, very tall. Milton Friedman was very, very short. So, Milton Friedman once said that Paul Volcker has the lowest height, IQ ratio among all economists.

Cho: Really?

Dr. Laffer: He said that. That was a nasty comment that was meant to be funny. But there was an implication also in that “I, Milton Friedman, have the highest height, IQ ratio.”

I hope you now understand the difference in monetary policy between Volcker vs. Friedman.

 

The Economist Way vs. the Powell Way

Dr. Laffer: Now, let’s go back to comparing Powell vs. Volcker.

There are two ways of looking at inflation: the Powell way and the economist way.

The Powell way is that if the demand for apples goes down, the demand curve for apples goes down and the price of apples falls. He believes that the price of apples, essentially the price of goods and services, is caused by too little demand or too much demand.

Cho: So, you’re saying that he’s only looking at demand.

Dr. Laffer: That’s right. But, as I mentioned earlier, those of us in economics look at the quantity or the supply of apples. If the quantity of apples increases, the price of apples falls. You cannot control the price level by changing aggregate demand. That’s the big debate there between different views of the world.

Powell sets interest rates. Volcker never did and he followed interest rates that were determined by the market. If market rates went up, he went up with them because he did not change the balance sheet. He approved of adjustments but they were unlike today’s monetary policies. Volcker’s approach was to maintain the monetary base for the most part and his monetary policies increase goods and services rather than causing a contraction. Volcker is market-focused, supply-driven, and Powell is demand-driven.

Cho: Why was Paul Volcker able to think in that way?

Dr. Laffer: Well, it’s common logic. I knew Volcker very well. I’d known him during the Nixon administration and then with the Reagan administration, and I’ve always been a big fan of Paul Volcker. He just thinks in a supply-side way when it comes to money. Instead of expanding the monetary base to control interest rates, he thought that you could control spot commodity prices, and in due course, that would bring inflation down or inflation would be controlled. And he’s completely right.

He’s also very right in the sense that you should use monetary policy to control inflation.

Inflation can occur in many ways. Inflation can occur because of too much money chasing too few goods. But inflation can also occur because there’s a huge change in aggregate demand— unbeknownst to the world. If that happens, you need to adjust the monetary policy to reflect the shift in demand to keep prices stable.

So, if demand for all goods and services goes way up, inflation would go up. Then you allow the monetary policy to change to reflect the stochastic shifts in demand.

That’s where Milton Friedman and Paul Volcker agreed that any type of stochastic change in demand should be adjusted for by changes in the monetary base. And you should not leave the monetary base unchanged.

Where Paul Volcker and I are on the same page versus Powell is how you adjust monetary policy in the monetary base for normal market changes in interest rates and inflation.

That’s where Volker and I would control spot commodity prices using a price rule rather than controlling the monetary base.

 

Dr. Laffer’s Take on the 2024 U.S. Election Results

Dr. Laffer: Dr. Martin Anderson (deceased, Ph.D. in Industrial Management, Massachusetts Institute of Technology), one of President Reagan’s closest advisors, in his book “Reagan in His Words,” said there are seven positions of political power in America.

• 1. President of the United States
• 2. The Senate
• 3. The House of Representatives
• 4. The Federal Reserve Board (the Fed)
• 5. The Supreme Court
• 6. State and local governors
• 7. State and local legislatures

Trump has won a great victory and the Republicans now control six of the seven political institutions. This has been a long time since this sort of skew has occurred. Today, only one position is controlled by Democrats and that’s the Fed. As Powell had said, if asked by Trump if he would resign, he said, “No, I will not.” It’s a very aggressive remark. He is going to be the opposition to President Trump. The Republicans will have even greater concentration of power as soon as Powell is removed after his term ends. Trump will have control of appointing the Fed members and then appointing the chairman.

What are the manifestations of this huge shift in the seven positions of political power in the United States? The manifestation of this will be in fiscal policy. Our government spending is taxation. Therefore, for the Republicans, what you’ll want to do is cut tax rates, broaden the tax base and lower tax rates to create economic growth through incentives. The Democrats under the Biden-Harris administration has done the exact opposite. I think you’ll see very tight controls on government spending and I think you’re going to see it in big numbers.

 

This Is How Department of Government Efficiency (DOGE) Will Succeed!

Cho: Mr. Trump announced that Mr. Elon Musk and Mr. Vivek Ramaswamy will lead the Department of Government Efficiency with the goal of reducing government spending. What are your thoughts on their project?

Dr. Laffer: The important thing here is to not only make government efficient, but also reducing the size of the efficient government. You need both efficiency gains and volume gains.

I was the chief economist in the Office of Management and Budget (OMB) from 1970 to 1972. I know this stuff really well. Ultimately, they will not be successful unless they can change the incentive structure inside government so that the government itself will want to become more efficient and want to become more parsimonious. They need to make it so that productivity gains inside government are rewarded with bonuses and that waste is responded to by punishment, by firings. If they are able to instill an incentive structure inside government, they can affect the future of America by a huge amount. If they just go through each department and each agency and cut off fat here, there and elsewhere, it’ll come right back.

What you need to do, if you really want to control government, is to restructure the incentives within government. You want [government] to do what it’s supposed to do efficiently, and then you want [government] to not do what it’s not supposed to do. That’s what you want from government. The only way you can make sure that happens is if the people in those areas which should not exist are rewarded for getting rid of that government spending and if those people in the areas where government should exist are rewarded for doing it efficiently. [Musk and Ramaswamy] must really focus not on misallocation of resources, but on instilling incentives so that the structure corrects itself.

[Musk and Ramaswamy] are not smart enough. I mean, no one’s smart enough to beat 360 million American people’s brains together. You can’t keep track of all of that. That’s why you need to set the structure. If you set the structure, they’ll take care of the problem because they follow incentives.

We’re all humans. With the correct incentive structure, people can create wonderful things. With bad incentive structures, very superior people will ruin the economy.

 

‘Incentive’ Is Not About Controlling People’s Lives

Dr. Laffer: What you do with your students, what you do with your children, what you do with the world, is try to set incentive structures so that when they do a good job, you want them to feel good on their own.

Let’s say one of your kids does something and you say, “No,” or you whack them on the hand and say, “No.” What you want to do is instill in them that when they go to that activity, they remember the “No,” they remember the whack, and they don’t want to do it. What you want to do is teach and instill in them when they do something good.

You helped your sister, you helped your brother, you were nice, and here’s a candy– you want them to feel good when they do something good, and you want them to feel bad when they contemplate doing something, so they do good things and they don’t do bad things. That’s what you try to do as a parent, as a teacher, as a friend. You’ve got to instill in people those incentive structures. But you can’t control their lives. You’ve got to set the instruction. That’s why I’m a supply-side economist.

Prices change what you do. If you see something and it costs more, you’re going to buy less of it. If you see something and it costs less, you’re going to buy more of it. If you’re selling something and the price goes up, you’re going to produce more of it. If you see something and the price goes down, you’re going to produce less of it.

That’s what economics is all about. It’s about changing the incentive structure so that you respond in a mature and constructive and positive way on the earth so that we can all be better off, so that poverty is eliminated, so prosperity is created. That’s the dream.

Cho: Yeah. That should be the dream.

 

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Editor’s column

Why Central Banks Should Respect the Market

It is Dr. Laffer’s belief, that demand-side economic policies which can only counter inflation by setting interest rates and keeping demand low, effectively creating a recession, do not capture the true purpose of economics– to bring “prosperity” and “growth.”

Dr. Laffer also believes that it is socialistic of the central bank to decide the interest rate, which is the price of money. Normally in a functioning market, when government bonds flood the market, prices fall and interest rates rise (as the price of government bonds and interest rates are inversely proportional). Thus, a natural alarm goes off in the market: “It would be dangerous for the government to keep raising its debt.”

This alarm doesn’t go off when the central bank controls the interest rate. The government is able to borrow money at a low interest rate, effectively making the central bank complicit in the government’s fiscal financing. This triggers inflation due to the ever-increasing amount of money in the market. Dr. Laffer is aware that normalization of the Fed’s balance sheet will take time to normalize the balance sheet; despite this, he is looking to restore a market-based capitalism in which interest rates are set by the market itself. In addition, he argues that monetary policy alone is limited in what it can do, and that we should take care of supply side through tax cuts and other measures, as well as speeding up efforts to reduce government spending.