International Deposit Insurance with Risk-Based Premia

Friedrich A. Hayek’s 1944 acclaimed Road to Serfdom (reproduced by the Institute for Economic Affairs online) supports social insurance for when markets work imperfectly, a long tradition in neoclassical economics now reflected in practice by the implicit or explicit social insurance linked to nearly all fiscal policy:

“Nor is there any reason why the state should not help to organize a comprehensive system of social insurance in providing for those common hazards of life against which few can make adequate provision (Hayek, p. 67)….If we are not to destroy individual freedom, competition must be left to function unobstructed (p. 69).”

Our bank insurance system is a part of social insurance for aggregate financial risk to competitive asset markets; efficient social insurance “completes markets” rather than distorting either competition or capital markets. Our monetary policy likewise provides social insurance based trust in exchange means that allows competitive goods markets to optimally allocate resources.

With respect to banking, also from the Institute for Economic Affairs, consider my 2009 “Commentary” found  on their website at

International Deposit Insurance

and attached Gillman Economic Affairs of Institute for Economic Affairs 2009.



WSJ: Time for Positive Interest Rates for Savers

Time for Positive Interest Rates for Savers

Federal Reserve interest rates of 2% to 2.25% aren’t neutral if the inflation rate is 2.61%.


Federal Reserve Chairman Jerome Powell speaks in Washington, June 13.
Federal Reserve Chairman Jerome Powell speaks in Washington, June 13. Photo: michael reynolds/EPA/Shutterstock

In “Pause Interest-Rate Hikes to Help the Labor Force Grow” (op-ed, Oct. 26), Federal Reserve Bank of Minneapolis President Neel Kashkari is mistaken in two important ways. Federal Reserve interest rates of 2% to 2.25% aren’t neutral if the inflation rate is 2.61%, as it is as of the third quarter of 2018. This gives a negative real interest rate of at least 0.36%. Only a positive rate of real interest in the 2% to 3% range is “neutral,” as during phases of the high-growth era of the 1980s and 1990s.

The Federal Reserve’s forcing of negative real interest rates for most of the 18 years since 2000, with the exception of about three years, has encouraged the substitution of capital for labor. This means the labor force gets paid less. This can help explain why the labor participation rate fell from 2000 to 2017, and now is finally starting to turn upward as interest rates rise.

Note that the Fed targets the personal consumption expenditures deflator index, and not the consumer price index, as a possible defense for President Kashkari. Everyone else across the globe uses the CPI as the key price-index measure of inflation.

Profs. Max Gillman

David C. Rose

University of Missouri

St. Louis

US Law on the Target Inflation Rate

Extract from new forthcoming Berkeley E Journal of Macroeconomics: Advances, “The Welfare Cost of Inflation with Banking Time”, Max Gillman, 2018.

Below is Section 2 of this article:

“US Law on the Target Inflation Rate”

According to the US Federal Reserve Bank the FOMC (Federal Open Market Committee) has since 2012 adopted an explicit inflation target of 2%. In January 2012 the FOMC stated (

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate (Board of Governors of the Federal Reserve System 2012).”

The same January 2012 FOMC statement continues that it will not specify the level of employment to be targeted:

“The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment” [bold added].

In contrast, current US law in the form of the 1978 Amendments to the 1946 Full Employment and Stability Act precisely sets both the targeted US inflation rate and the US unemployment rate. For inflation, it states that the US inflation rate should be 3% by 1983 and should be 0% by 1988 and afterwards, unless it conflicts with the employment goal. For unemployment, rates of 4% for aged 16 and over, and 3% for aged 20 and over, are to be met within 5 years of the passing of the 1978 Act (so by 1983).

Further, the Act specifies that only the President or Congress can change these goals. The US Federal Reserve Bank (Fed) is not allowed, by any existing law, to change these goals. Therefore, it is not authorized, without Presidential or Congressional mandate, to set a 2% inflation rate target as it did in 2012, because the target is currently specified in law as zero percent unless it conflicts with achieving the unemployment target. And it is not authorized to change the target unemployment rate of the 1978 Act.

(Public Law 95-523, passed October 27, 1978, is known as the Humphrey-Hawkins Act or officially within its Section 1 as “Full Employment and Balanced Growth Act of 1978”.
Alternatively, a pdf of the law is found at

The Fed seemingly has a big loophole in that the 1978 Act specifies that the inflation rate target may be higher if it conflicts with the unemployment rate targets. But when the Fed set its 2% inflation target, it also specifically stated that the inflation target does not affect the unemployment rate, in that this is set by “nonmonetary factors”. So the Fed closes the loophole offered to it under the 1978 Act by saying the inflation and unemployment rates are “largely” unrelated.

However the Fed’s logic for not setting an unemployment rate goal is faulty. Rather than its authority to set unemployment rate targets being based on some envisioned relation between the inflation rate and the unemployment rate, the Fed has no authority to set unemployment rate targets since the fact is that these are already set in the 1978 Act, which provides no authority to the Fed to alter these targets. It is the specific US 1978 statutory law, which specifically precludes the Fed from having authority to change the unemployment rate targets, that implies that for the Fed: “it would not be appropriate to specify a fixed goal for employment”. The end result is that today the Fed has given no Congressionally valid reason for setting a 2% inflation rate target in deliberate contradiction of the 1978 Act’s target of a zero inflation rate.

There are four relevant sections of the Act, 4.b1.-4.b.4, which respectively set out the unemployment rate goal, the inflation rate target for the first five years, the inflation rate target for all years after 1988, and the authority for changing these targets.

“Section 4.b.(1). reducing the rate of unemployment, as set forth pursuant to section 3(d) of this Act, to not more than 3 per centum among individuals aged twenty and over and 4 per centum among individuals aged sixteen and over within a period not extending beyond the fifth calendar year after the first such Economic Report; and
Section 4.b.(2) reducing the rate of inflation, as set forth pursuant to section 3(e) of this Act, to not more than 3 per centum within a period not extending beyond the fifth calendar year after the first such Economic Report: Provided, That policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment.”

“Section 4.c.(2). Upon achievement of the 3 per centum goal specified in subsection (b) (2), each succeeding Economic Report shall have the goal of achieving by 1988 a rate of inflation of zero per centum: Provided, That policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment.”

Section 4.d states that only the President or Congress may change these goals:

“if the President finds it necessary, the President may recommend modification of the timetable or timetables for the achievement of the goals provided for in subsection (b) and the annual numerical goals to make them consistent with the modified timetable or timetables, and the Congress may take such action as it deems appropriate consistent with title III of the Full Employment and Balanced Growth Act of 1978.”

Using data from the US Bureau of Labor Statistics, the unemployment goal of 4% for over 16 years of age was achieved for briefly in December 1999, and for several months into 2000, when it dipped into the 3+% range. Now, in April, May, and June 2018, the rate has been again below or equal to 4%.


The rate for ages over 20 has been below 4% since September 2017.
The legislatively binding US law, which sets the US inflation rate to be 0% permanently, seems to be contraindicted permanently such that a permanent 2% inflation rate target is set “de facto” by the Fed. Would this contradiction of US law be based on the inability to meet some unemployment goal, it might be acceptable as an interim policy. But, 1) the Fed FOMC openly admits in January 2012 that monetary policy has little if any ability to affect the long term employment rate (as quoted above). And 2), the goals of the 1978 law on unemployment are now largely met, although having taken longer than the five years allowed. This achievement of the statutory US unemployment goals seems to imply unambiguously that the inflation target should now be zero.

To summarize and emphasize the conundrum here: First, the Fed claims the 2% inflation target is not chosen to achieve the unemployment goal, since it cannot affect unemployment. Second, the unemployment goal appears to have been met as of now anyway. Third, the inference results that the Fed appears to be contravening statutory law of a 0% inflation rate by their self-established 2% target. If so, then by US law, the Fed 2% inflation target is a judicially challengable over-reach by the Fed relative to US statutory law. While economists can consult the lawyers, this is clearly controversial, if not illegal, policy practice by the Fed, even though there not much of a fuss made over it by academics. Economists though can propose ways to quantify the cost of the Fed’s contraindiction of the zero inflation rate in favor of the 2% target. This is done here through the standard approach of the welfare cost of inflation, in terms of a 2% rate compared to zero.

WSJ:”Fed Should Slowly Unwind Excess Reserves”

The Wall Street Journal: Letter

“Fed Should Slowly Unwind Excess Reserves”

Before 2008, competition between banks forced them to loan out or otherwise invest excess reserves.


Sept. 26, 2018 3:15 p.m. ET

SEC chairman, Jay Clayton in April Photo: Yuri Gripas/Bloomberg News

Regarding your editorial “Sharing the Wealth of Markets” (Sept. 21): Yes, recent stock price increases aren’t creating new wealth as broadly as most would like because the market isn’t providing adequate liquidity for the kind of firms that drive economic growth. We believe that much of the blame rests with Federal Reserve policy.

The New Keynesian model the Fed uses led, in part, to paying banks interest on excess reserves in 2008. Before 2008 excess reserves were virtually zero but now hover near $2 trillion. This is no longer a rational response to the financial panic of 2008-09. Interest payments made by the Fed on those reserves have helped make major banks richer by not issuing loans from reserves but instead earning interest at no risk.

Before 2008, competition between banks forced them to loan out or otherwise invest excess reserves. This produced new economic activity that produced economic gains outside the banking sector. If the Fed began reducing the interest paid on excess reserves, the excess reserves would begin to enter the system and make capital available to startups by increasing liquidity.

If the near $2 trillion of excess reserves entered circulation tomorrow, it would soon expand the money stock, igniting a major inflation. Interest rates paid on excess reserves should therefore be cut in several stages. But if there ever was a compelling argument for paying banks to hold on to excess reserves, that time is past. The sooner the Fed unwinds this practice the sooner we can avoid frustrating the emergence and expansion of a new generation of wealth-creating firms.

Profs. Max Gillman and David C. Rose

University of Missouri-St. Louis

Comment on “Cold Turkey and Moral Hazard”

Thomas Gordon : Writing in Wall Street Journal: December 14, 2017

@Max Gillman Good comments and informatory about why banks are now paid interest  on reserves.   As it concerns the article, I don’t think they were paying a huge interest rate (I thought it was less than 1%, but probably more than most banks were paying depositors ).   Not enough in my mind to get banks to hold excess reserves, but I suppose it is risk free.   The other unspoken thing is that back when Wachovia and WaMu were going broke maybe Fed/Treasury type people were looking for ways to strengthen the banks.  Pay them directly and you get a riot about subsidizing hated banks.   Do it this way and you’re “paying interest on reserves”, a topic that puts most people to sleep.

Avatar for Max Gillman

Max Gillman

@Thomas Gordon @Max Gillman

Thomas, Thank you. The reason why the interest is still “high” is that every time the Fed “raises interest rates”, it is actually raising the Interest rate on excess reserves; the Federal Funds rate remains (since 2008) below the interest rate on excess reserves. This way the Fed induces these 10 systematically important banks to keep holding the (now) $2.1 Trillion in excess reserves. If lent out, and so there were zero excess reserves,  a normal “money multiplier” would cause the money supply to jump by 10 times $2.1 Trillion, or by $21 Trillion dollars. GDP is about that now, so it would be an amount of new money equal to GDP. Inflation would rise significantly, but capital markets would “normalize”. Real interest rates on short term debt would no longer be negative. So I believe the jump in inflation would be best overall, and the elimination of interest on excess reserves the route to such normality in Capital markets.

Turning a Good Blueprint for Tax Reform into a Great One


April 2017

Two weeks ago President Trump told House leaders that he liked most of the House Ways and Means Committee’s “Blueprint” for tax reform. The blueprint does indeed significantly improve tax policy in a number of ways. But a careful consideration of what the latest economic theory has to say about economic growth suggests that it could be even better. Republicans should not miss this once in a generation opportunity to significantly improve the US tax code.

Governments tax so they can spend. An important fact about federal spending is that in the US over the last 60 years it has been a rather stable proportion of GDP (we ignore entitlement spending since, for the most part, these programs have dedicated funding). The trend is downward from about 24% (in 1958 and 1967) to about 18% (1998-2000). In 2016 it was a little over 19%.

As a practical matter, then, the ultimate objective of tax policy should be to extract enough resources from the economy to support spending of 18-20% of GDP as efficiently and as fairly as possible. Extracting less, such as what has been the average tax revenue share of GDP over the last 60 years of 17% leads to ever increasing debt. Extracting more reduces consumption for no good reason and weakens incentives that support rapid growth.

The blueprint can be improved by adopting a top rate of 22% on personal income and a 22% rate on all corporate profit coupled with: 1) eliminating taxation on dividends (to avoid double-taxation of dividends and remove the differential treatment of debt and equity), 2) eliminating capital gains taxes on stock holdings, and 3) removing all deductions and loopholes except those that exist to properly define corporate and personal income.

There is a very important finding in macroeconomic theory that has gotten surprisingly little attention. In pioneering work Robert Barro, in an article in the Journal of Political Economy (1990), considered government spending to be a constant share of GDP. Then Stephen Turnovsky, in an article in the Journal of Monetary Economics (2000), showed that under this condition income tax policy should be neutral with respect to rates applied to human capital (personal income) and physical capital (corporate profit).

This type of tax neutrality is an established result that no one we know of has successfully challenged. It makes intuitive sense that policy should not favor one over the other and thereby distort resource allocation.

Moreover, no serious economist we know of supports the double taxation of corporate profit. So the real question is, therefore, how to best insure that all corporate income is actually taxed, but only once. Some favor accomplishing this by not taxing corporate profit because dividends will produce personal income which will ultimately be taxed anyway.

This approach is attractive because it recognizes that it is people, not firms, who ultimately bear the burden of paying taxes. But the problem with this approach is that not all corporate profit is distributed as dividend income that is later subject to the personal income tax. This simple fact is particularly relevant when considering a zero corporate profit tax rate.

A zero corporate profit tax rate will induce firms to hold back on dividends so as to reward shareholders mainly through capital gains appreciation arising from retained earnings. This subsidizes physical capital relative to human capital by inducing more earnings retention at zero cost to the firm. If retaining such amounts for firm reinvestment was the best use of these funds, it would have happened already without the tax code inducing such action.

There is another benefit from taxing corporate profits at the source rather than indirectly through personal income that is increased by dividends. The latter approach requires monitoring over 100 million payers to minimize avoidance. Our society makes it hard for government to know much about each household’s finances. Taxing corporate profits at the source, however, requires the monitoring of far fewer firms. And with corporate firms especially, their financial situations are very transparent. This means the effective rate – after accounting for avoidance – is more likely to be close to the official marginal rate when corporate profits are taxed at the source.

Achieving neutrality in how human capital and physical capital is taxed also affects how capital gains should be treated. If we choose to tax corporate profits at the source, then capital gains realized through the appreciation of the value of stock holdings should not be taxed. This approach also cuts off a means by which the federal government can increase taxes through inflating the value of the currency to drive up the price of stocks.

This problem is often cited as a rationale for having a lower tax rate on capital gains, but our approach renders this issue moot. It also vastly simplifies the filing of tax returns by eliminating at one stroke the vast financial industry of “cost-based” accounting of stocks, needed to determine the size of the reported capital gain.

Most discussions about tax rates involve a false choice between having a flat or progressive tax system. We think the blueprint can be greatly improved by not falling prey to this false choice. For personal income, an approach that is better than a pure flat or a thoroughly progressive tax is a progressive system that reaches its top bracket so quickly that it is effectively flat for the vast majority of income for the majority of tax payers. This is where progressivity is needed most – to have a lower or zero rate for those who earn the least. What matters most is not that the rate be perfectly flat, only that it is flat for the people who will be paying most of the taxes.

A tax blueprint with a top rate of 22% on personal income and a flat rate on all corporate income would be a better blueprint. It would move us much closer to taxing human and physical capital equally, which removes a major inefficiency of the current system and the existing blueprint. Its rate of 22% should be high enough to ensure sufficient revenue yield to cover 18% – 20% of spending out of GDP given there is always some avoidance and given that the lowest income individuals will pay lower rates (some zero). Finally, 22% is just below the corporate rate for a number of large countries. This will give American firms a stronger incentive to stay in the US and foreign firms a powerful incentive to move to the US.

Max Gillman is the F.A. Hayek Professor of Economic History and David C. Rose is a Professor Economics, both at the University of Missouri-St. Louis.

Is the House blueprint for tax reform good for St. Louis?

St. Louis Post-Dispatch

St. Louis Post-Dispatch Column

Is the House blueprint for tax reform good for St. Louis?
  • By Max Gillman and David C. Rose
  • Mar 8, 2017

President Donald Trump recently stated that he will release an outline for comprehensive tax reform in the coming weeks, and if his previous statements are accurate, his eventual plan will likely look substantially similar to the House Ways and Means Committee’s blueprint for tax reform. It is not too early to ask if the other parts of the plan are generally good for the country and St. Louis.

The blueprint plan reduces both personal income tax rates and the corporate profits tax rates. It also simplifies a number of elements of the tax code. Current rates are high enough to reward avoidance behavior for both individuals and firms. This reduces the effective base upon which the rate is applied and suggests that a reduction in rates might actually increase tax revenues.

Modern models of the economy show that the lower rates are on personal income and corporate profits, and the closer these rates are to being equal on average, the better for economic growth. These models also show that the flatter both rates are, the better. The House blueprint plan moves in the right direction on each of these fronts.

Through most of the 20th century, the U.S. was the manufacturing juggernaut of the world. As a competitor to U.S. firms and workers, China, which is today an industrial giant, was completely out of the picture. This was also true for many countries in Eastern Europe. But all of that has changed. Whereas the U.S. federal tax rate is 35 percent, the European Union and world averages are both about 22.5 percent, and Russia’s rate is 20 percent. Higher rates relative to the rest of the world drive firms out of the U.S. so they can enjoy lower tax bills.

Our firms and workers must now compete with firms and workers from not only China and Eastern Europe, but increasingly with South Korea and Southeast Asia. Even in Northern European countries like Ireland, with its 12.5 percent corporate tax rate, the competition is heating up.

The St. Louis region has been hit hard in recent years by this foreign competition, particularly in manufacturing. Unfortunately, the harm caused by this trend does not fall equally. Those hurt the most are honest, hardworking, unskilled workers who could have earned a good living in manufacturing employment.

These changes have hit St. Louis especially hard because manufacturing has historically been such an important foundation for our regional economy. It follows that increasing the net rate of return on capital investment as well as relaxing and streamlining capital deduction rules will help the St. Louis region more than many other regions since the St. Louis region has been faltering because of the lack of manufacturing jobs.

Still, St. Louis has many natural advantages. Being centrally located and serving as a rail and interstate hub, it is cheap to bring unrefined resources in and cheap to ship them out. Fresh water is a very important resource, and we have it in great abundance. Strong education produces a good workforce even among unskilled workers. Remove the corporate profit tax impediment and St. Louis’ natural advantages will likely reassert themselves.

Additionally, in the U.S., politicians have been using corporate tax policy as a political game. The higher the average effective rate, the more valuable are tax loopholes. This makes it easier for politicians to buy votes from corporations in return for loopholes. The result is a system with high rates and low yield in part because it is riddled with loopholes that reward the politically savvy at the expense of everyone else.

These loopholes are not just unfair to the rest of us. They also distort investment decisions. The richest firms are able to pay the most to get loopholes that are favorable to them, so high rates plus lots of complexity that hides loopholes is a good example of how the rich get richer at the expense of everyone else.

The House blueprint brings down the top and average effective rates significantly but, even more importantly, it closes many of these loopholes. This is fairer and better for general economic growth, and we think the St. Louis region stands to benefit.

Max Gillman is a professor of economic history and David C. Rose is a professor of economics, both at the University of Missouri-St. Louis.

Cold Turkey and Moral Hazard : Why the Fed Should Stop Paying Interest on Excess Reserves to Banks

With the December 2017 quarter of a percent hike in the Federal Reserve Bank interest rate to 1.5%, banks will receive 1.5% interest on reserves parked at the Fed instead of lending them out. Lending them out means added investment. Lending out the excess reserves means increased demand deposits at private banks. And increased demand deposits means more money supply as measured by the M1 aggregate of currency in circulation plus demand deposits.

With $2.1 Trillion in excess reserves now parked at the Fed, private banks on an annual basis will earn (0.015)($2.1 Trillion) or $31.6 Billion dollars. Fed minutes apparently show this 31.6 going to only 10 banks. That is $3.16 Billion being paid per bank on average by the Fed, outside of the Congressional Budget process.

Why? Interest on excess reserves (IOER by its acronym) was begun by the Fed in October 2008 at the height of the financial crisis. At first substantial interest was paid for excess reserves. (See Federal Reserve Data at ). Once the liquidity crisis passed, the Fed kept paying such interest and excess reserves, which are those reserves greater than what banks are required to hold, began piling up. They reached $2.6 Trillion and now are finally starting downwards, standing at $2.1 Trillion. In contrast, required reserves are the 10% of demand deposits that are held as reserves at the Fed (Dodd-Frank 2010 legislation changed some reserve requirements, but this is irrelevant here).

When the Fed buys Treasury debt, the money multiplier occurs as this creates excess reserves that are lent out until only the required reserves are held. But the Fed has induced “moral hazard” by paying banks not to lend out reserves. This increases the probability of the bad state, which is too low of an investment level, even after the crisis has passed. So the money multiplier is suppressed. Excess reserves earn interest instead of loans by banks and investment by firms earning market interest rates.

By raising the “interest rate” in December, the Fed is not raising the Federal Funds rate. It is raising the interest rate on excess reserves: the IOER. The Federal funds market is basically defunct since it is used by banks to borrow from other banks in order to meet their weekly required reserve level. Now reserves are in excess.

If all of the excess reserves are lent out now, inflation will increase above the Fed’s 2% target. So the Fed does not advertise the off-the-federal-budget expenditure that it makes exclusively to the private bank sector. The Fed has become a drug addict: it keeps raising the opioid amount that banks receive every time it increases interest rates. Private banks are happy. The Fed is happy since its inflation target of 2% has not been exceeded nor is its ability to meet its target seriously threatened (generally meaning that the inflation rate is 2% or less). Ironically the Fed has not been able to understand why inflation had been low, below 2%, for so long. It is because they have paid banks not to lend out money, which the Fed knows of course.

The Catch 22 is that if the Fed stops paying IOER, the excess reserves will get lent out and the inflation target gets a miss. Too bad. An immediate ceasing of the subsidization of the bank sector should begin as soon as possible. Jerome Powell knows of this, but has he either the moral fiber, a consensus over the issue, and/or the courage to stop it, by himself? Probably not.

Yes the inflation rate would jump, but not for so long. Then interest rates could be truly normalized, with a normal positive real interest rate. This means the short term Treasury Bill rates rise above the inflation rate.

Why was interest on reserves begun? Long story. Economists argued that if we “tax” banks by making them hold reserves at the Fed, then we should decrease that tax by paying interest on the REQUIRED reserves. Even this would be a subsidy. Why? Because banks would hold say 7% of reserves anyway. So the tax is only on the 3% extra amount of reserves held when 10% of deposits are held as reserves. But the Congress passed a 2006 law (Financial Services Regulatory Relief Act) allowing the Fed to pay interest on reserves, starting in 2011. Here the intent was to pay interest on required reserves, as consistent with the academic debate on whether this was a good idea or not. Interest paid on excess reserves was not part of this debate (although some might debate this). Of course banks favored this interest on required reserves. It is still a subsidy to banks since they would have held some zero- interest earning reserves anyway as a natural part of running a financial institution. Crisis hit in 2008 and the law was allowed to start in 2008.

Most insidiously of all, the Fed allowed interest to be paid on all reserves, not just required reserves. This began the Fed’s complete control over the Federal Funds market. In order to avoid appreciating against the US dollar, major trading partner countries followed the US and increased their money supply in order to create a persistent liquidity that suppressed short term interest rates, while inflation was above these rates. This achieves negative real interest rates, matching the US and avoiding currency appreciation.

Here a study of the Swiss National Bank actions is recommended (at first they appreciated and then started printing money and buying anything they could, now owning a substantial share of the Swiss private sector: because they had little government debt to buy).

Going Cold Turkey on IOER, and setting it to zero, is the easiest way out of the Fed’s morass, its quagmire, its “illegal” subsidization of the private bank sector. Sure. Pay interest on REQUIRED reserves, but not on excess reserves. That policy, paying IOER, causes moral hazard. The increase in the probability of the low investment “state” of the economy has caused the Lost Decade that the US is finally exiting. Let it exit it completely and stop the Fed’s direct revenue subsidization of the “Lucky 10” private banks who get the IOER. $31 Billion is a lot of money to any private company, especially free money from the US government.

Some Corporate Tax Reform History & the Inflation Tax: Lecture given at the Discussion Club of St. Louis, March 19, 2014:

 Presentation by Max Gillman


Thank you very much for having me before this distinguished group. I especially thank Harry Langenberg, Dave Rose and William Rogers for this honor. My talk involves some monetary theory, history, and policy with a neoclassic economic perspective that monetary policy is a part of fiscal policy. Rather than a Federal Reserve system acting independent of the government, I will develop a sense in which a unified budget including the Fed may actually be an optimal way to conduct monetary policy.
My talk is a-political. In caution, it is without rabble raising . Without flag waving. And without populist anthems. However I will talk about God.

Last month we heard from Christopher DeMuth about how the debt is high, bad, and not so hard to fix if we just let the do-ers do and the talkers talk. My view is less sanguine. I also think key policy issues can be resolved. But I would never call it easy to do as it might appear from a policy think tank perspective. Rather it may only be possible if the proposal achieves a certain, in the concepts of Adam Smith’s third Treatise called Lectures on Jurisprudence, political equilibrium similar to an economic equilibrium by which markets clear.
My personal perspective is formed from seeing the close interaction between proper budgetary processes and good reform of taxes. For this I will use first my experience working as a legislative aide to Congressman Bill Gradison, a Republican from Cincinnati, in the Reagan era early 1980s. I will also use my academic career that has followed certain taxation issues.
Consider that in the US Constitution, The Origination Clause, also known as the Revenue Clause, is as follows:
“All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.”
This was part of the Great Compromise that was key in selling the Constitution’s Ratification. During debate on its passage, in the Federalist Papers (58), James Madison wrote “The house of representatives can not only refuse, but they alone can propose the supplies requisite for the support of government. They in a word hold the purse.”

Bill Gradison served on the House Ways and Means Committee to which all tax bills are referred according to House Rules. This was the era when Dan Rostenkowski was Democratic chair of the Committee, Barber Conable was ranking Minority member of the committee, and the quite knowledgable former head of the committee, Wilbur Mills, was reduced to lobbying Bill Gradison after leaving Congress.
Gradison is a PhD in Business from Harvard with an Economics specialization. He championed the idea of income tax bracket indexing to inflation. This was important during this high inflation period because only when this bracket-indexing was introduced into the Conable-Hance substitute Ways and Means Committee bill at the last hour was Reagan’s 1981 tax reduction able to pass Congress.
After that I arrived and as Ways and Means legislative assistant for Bill, we did several other tax initiatives. Bill knew the value of these from his career and I knew the value of these from taking Arnold Harberger’s public finance class: (don’t undervalue the kick from a good education). One of Harberger’s ideas was that the Investment Tax Credit of 10% from Kennedy’s era was economically inefficient. It biased investment towards shorter term horizons away from longer term horizons. I inferred that it should be eliminated with the revenue gained to be used to lower the corporate tax rate in a revenue neutral fashion that increased the incentive to invest.
1. However there were some serious practical problems to further tax reform that we ran up against immediately. Most of all was that the tax base itself was poorly defined because of uncontrolled growth in fringe benefits. Fringe benefits can be part of statutory law, like the one for Health care, or they can be determined by IRS regulation. Unfortunately, every time the IRS issued a regulation a group would complain to Congress and Congress reacted by prohibiting the IRS from issuing regulations clarifying what constituted a fringe benefit. They continued this prohibition every two years for some 10 years at that point. This allowed fringe benefits to grow without constraint.
Therefore in order to work on some good tax reform, it required clearing up the issue of how to determine fringe benefits. Economics to the rescue again. I drafted up a white paper for the Ways and Means Committee members and staff that showed how each of 40 different fringe benefits could be defined relative to the marginal cost that the benefit incurred. For example, the 20% discount that employees might get at a clothing store like Federated might be reasonable because the employees did not use the marketing and advertising costs since they already knew about the stock. The cost to Federated of employee bought clothes was less than the retail cost. So this gave a range for a reasonable discount that was non-taxable as income, and so a non-taxed fringe benefit. Staff then worked up this Marginal Cost foundation into a bill that Gradison introduced and it eventually became the little known Tax Reform Act of 1984.
2. With the tax base now cleaned up, it was easier to turn to tax reform. Bill Gradison liked the idea of eliminating the 10% Investment Tax Credit (ITC) and using the revenue gained to reduce the corporate tax rate, which was then at 46%. He let me meet with and implore the staff of the Joint Committee on Taxation to determine by how much we could reduce the corporate tax rate if we eliminated the ITC. After some considerable months of bugging them, they produced a number: we could lower the corporate tax rate by 7 points from 46 to 39% from this one provision alone.
Bill then instructed me to prepare a letter explaining this for Reagan’s then new Bipartisan Commission on tax reform that was headed by Treasury Secretary Donald Regan. By eliminating in addition a clutch of other lesser tax credits and subsidies, it was determined that the corporate tax rate could be reduced to 33%. This was accepted by Bob Dole as head of the Senate Finance committee, and by the President and Congress and this became the Tax Reform act of 1986. Corporate tax rates have never been reduced again since then, with Clinton actually raising them back up by 2%. And that is where we are today, one of the highest corporate tax rate among developed countries.
3. Now let me switch gears to a budgeting-plus-tax-reform issue in the Social Security Reform act of 1983, the last time that the Old Age and Survivors trust fund was reformed. Before this act, the social security trust funds were on the unified budget of the US. This had only come about in 1969 because President Johnson wanted to hide the US Treasury deficit from the Vietnam War with the Baby-boom Trust Fund surpluses that were accumulating at the time off-budget. Off-budget is in a sense better for these trust funds since they cannot be used to finance the general Treasury budget, nor can the Treasury finance these funds with general revenues: only the payroll taxes can finance trust fund expenditure. So the trust funds were on-budget and needed reform because in 1981 they were going broke relative to spending. Bob Dole had made the mistake of proposing Social Security benefit cutbacks before Reagan’s first midterm election and it was said this led to the Republicans losing 24 seats in the House. So Gradison proposed as part of the reform that we take Social Security back off-budget so the reform could be done outside of the political tinderbox of the general Treasury deficit. This was adopted by Reagan Bipartisan Commission on Social Security headed by Alan Greenspan, and it became law in the 1983 Act, along with various tax and benefit changes that refinanced the system supposedly until around 2017, which looks today to be about right.
Therefore in both tax and spending reform, getting the tax base “budget” for tax revenues well defined, and getting the budget for spending funds well-defined, became key to successfully reforming both broad tax rates and our social welfare system.
Second, in terms of my experience upon which I will draw this evening, I will now use my mainly academic experience about the history of monetary economics and what economists call the inflation tax. Naturally, one would think that all taxes must originate from the Ways and Means Committee in the US House of Representatives. Yet we also know that Volcker, Greenspan, and Bernanke have been called the most powerful men in the US, or in short Gods. If you dont believe in this type of God, you need to ask yourself the following question: Why are they treated like Gods?
My answer is not religious. It is that the Chairmen of the Board of Governors of the Federal Reserve System largely determine by themselves the level of the inflation tax. No single individual in Congress can make such a claim for any tax, yet the Chairman of the Fed can. Again: Why?
The Fed was established in 1913 when the US was on a gold standard that kept the price of gold set at $20.67 per ounce of gold, at which price one could exchange government currency for government owned gold. While there were breakdowns shortly thereafter in the gold standard during WWI, and again in WWII, the US remained largely on a gold standard after WWII. At that time the Bretton Woods Treaty of 1946 reestablished a US led gold standard whereby the US kept the price of gold at $35 an ounce.
While I am not an expert on the gold standard, I am currently conducting research on the relation between gold and “fiat” currency. Fiat currency is unbacked by gold: it cannot be traded in for gold. This pure Fiat currency is what the US established in 1971-1973 when Nixon ended the Bretton Woods agreement and the US left entirely the gold standard. What this means is that it is only after 1973 that the Fed could increase the money supply to any degree it wanted, or say, the Treasury needed. And it was only then that the Fed chairmen became Gods.
Now it is not a coincidence that as Bretton Woods was breaking down that President Johnson put Social Security on-budget in 1969. Both were the result of the US running a large deficit from financing the Vietnam War and printing money to pay for this deficit. Before Bretton Woods broke down the other signatures to the Treaty had to soak up our excess dollars by printing their own money to buy our dollars. This exported the US inflation to other countries, while the US kept the price of gold at $35 an ounce, until finally Nixon gave up the sham (remember his price controls, also used in WWII) and inflation in the US was allowed to rise unfettered with growth in the US money supply.
The 1970s until 1981 was our largest historical inflation experience post WWII. The other two periods were WWI and WWII. The Fed was conveniently created just before WWI when it subsequently printed a lot of money to finance the WWI, despite the gold standard; it did the same in WWII; and it did the same in what I am embarrassed to say our macroeconomics principle books call a peacetime period of the Vietnam War in the 1960s and 70s.
Therefore the question of all monetary economists in the pure Fiat era is: What is the best monetary policy that the Fed should follow? Neoclassical monetary economists would put this as: What inflation tax should the Fed levy and how should they do it?
Wicksell, Irving Fisher, Hayek, Milton Friedman and their modern followers all consider that monetary policy was such that printing money caused inflation. They also all have stated that printing money in order to temporarily drive down market interest rates is a very dangerous game that distorts investment and is economically inefficient. Unfortunately Bernanke [now Yellen] does not agree.
In fact, this split amongst prominent economists dates at least from the beginning of modern neoclassical monetary theory, with Irving Fisher’s equation of exchange that put the quantity theory of money into mathematical form. John Maynard Keynes at first fully embraced Fisher’s quantity theory in his 1923 Tract on Monetary Reform. There he prescribed how to achieve Fisher’s proclaimed goal of stabilizing the economy-wide price level, and so inflation: Keynes said this could be done simply by letting money supply follow money demand.
So far so good. But while Fisher stated that the stock market had no reason to decline in 1929, and he subsequently lost his wealth in the Crash, Keynes foresaw the coming of WWII and the crash of the newly won European markets. In his 1922 Revision of the Treaty, he writes that the WWI Treaty of Versailles is “crumbling” because the Central powers who lost WWI cannot pay the Versailles Debts imposed upon them in order to pay for the war damage. He advocated instead what we today would call the Marshall plan, for the losers of WWI. Keynes was correct and Germany spun into a 1920s hyperinflation and the Rise of the Third Reich, and then WWII.
The worldliness of Keynes led people to pay high respect to his famous Treatise on Money in 1930. There Keynes explicitly said to throw away Fisher’s theory of the price level as determined by money, and instead he advocated a price theory based on average cost, as in his teacher’s treatise; this teacher was Alfred Marshall and his book was the neoclassical foundation of modern Economics: the Principles of Economics, which had 8 editions from 1890 to 1920. In doing this Keynes came up with a brilliant theory of the business cycle, in which printing money or having the government spend money would get nations out of recessions. His analysis was at the basis of his even more famous 1936 General Theory of Employment, Interest and Money.
Unfortunately, unlike Marshall, Keynes defined profit as Investment minus Savings. When positive, the economy expands, and when negative it contracts. So in a contraction the government can spend uninvested savings and force an economic recovery. But the problem here is that profit instead is a random residual in the modern neoclassical economic formulation in mathematics that Keynes’s star student Frank Ramsey established in 1928. It is not equal to Investment minus savings and so the whole Keynesian edifice theoretically collapses.
That has not bothered the modern Salt-water economists who like it when economists can have a big say in what the government does, and who are happy to put the financing of expenditure off somewhere in the future. This is opposed to the Fresh-water economists who think that government spending is key for social insurance activity, like Hayek, but that spending needs to be carefully justified and always financed by well-known taxes.
This brings me to my conclusion on how the monetary policy debate can neatly evolve into a dying ember. The Federal Reserve System is an off-budget entity. When they bought a trillion dollars in mortgage securities, instead of Geithner at Treasury buying it, the White House incurred no budget expense that Congress had to approve through the budget process. If Treasury had bought this directly, instead of the Fed, then the budget deficit would have been increased by the estimated expense of this subsidy in the fiscal year during which the mortgages were bought by the Fed.
What has been Unconventional about Fed policy is that it has secretly in plain view for all to see allowed the Executive branch to avoid the Congressional budget process over these asset purchases. Formerly the purchasing of the exact same type of mortgage debt was done by the then-off budget branch of Treasury called the Federal Financing Bank. Gradison and I held a Ways and Means Committee hearing into this skirting-of-the budget practice in the early 1980s and introduced legislation that resulted in putting the FFB on budget as it is to this day. This left the White House to privatize Fannie and Freddie in the early 1980s, with the impact that in the 2008 Crash the Fed became the new way to government-guarantee the debt anyway, once again in an off-budget fashion. It facilitated a huge financial crisis, major recession, and brings the current spectre of rising inflation looming in the future.
Putting the Fed on budget would require Congressional budget approval for all Fed spending. This would not affect any claims to Fed independence unless that claim means unlimited budgets. This would effectively put the inflation tax into the Congressional budget process for the first time since the advent of the modern Fiat currency. As such, Congress would likely vote to keep the inflation tax low and steady, except with specific approved increases during times of War. As a result, our national economic fiscal policy would include inflation tax policy simultaneously and be done more efficiently with less distortions to markets, not to mention that it would be more consistent with the Spirit of the US Constitution. This Constitution was meant to replace monarchies, who sometimes viewed themselves as Gods. Putting the Fed on-budget would make the only remaining Gods in the US once again reside within each person’s own identity.

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