Ten Great Economic Myths

Email Print



This article
is featured in chapter 2 of Making
Economic Sense

Our country
is beset by a large number of economic myths that distort public
thinking on important problems and lead us to accept unsound and
dangerous government policies. Here are ten of the most dangerous
of these myths and an analysis of what is wrong with them.

Myth 1:
Deficits are the cause of inflation; deficits have nothing to do
with inflation.

In recent decades
we always have had federal deficits. The invariable response of
the party out of power, whichever it may be, is to denounce those
deficits as being the cause of perpetual inflation. And the invariable
response of whatever party is in power has been to claim that deficits
have nothing to do with inflation. Both opposing statements are

Deficits mean
that the federal government is spending more than it is taking in
in taxes. Those deficits can be financed in two ways. If they are
financed by selling Treasury bonds to the public, then the deficits
are not inflationary. No new money is created; people and institutions
simply draw down their bank deposits to pay for the bonds, and the
Treasury spends that money. Money has simply been transferred from
the public to the Treasury, and then the money is spent on other
members of the public.

On the other
hand, the deficit may be financed by selling bonds to the banking
system. If that occurs, the banks create new money by creating new
bank deposits and using them to buy the bonds. The new money, in
the form of bank deposits, is then spent by the Treasury, and thereby
enters permanently into the spending stream of the economy, raising
prices and causing inflation. By a complex process, the Federal
Reserve enables the banks to create the new money by generating
bank reserves of one-tenth that amount. Thus, if banks are to buy
$100 billion of new bonds to finance the deficit, the Fed buys approximately
$10 billion of old Treasury bonds. This purchase increases
bank reserves by $10 billion, allowing the banks to pyramid the
creation of new bank deposits or money by ten times that amount.
In short, the government and the banking system it controls in effect
"print" new money to pay for the federal deficit.

Thus, deficits
are inflationary to the extent that they are financed by the banking
system; they are not inflationary to the extent they are underwritten
by the public.

Some policymakers
point to the 1982–83 period, when deficits were accelerating
and inflation was abating, as a statistical "proof" that
deficits and inflation have no relation to each other. This is no
proof at all. General price changes are determined by two factors:
the supply of, and the demand for, money. During 1982–83 the
Fed created new money at a very high rate, approximately at 15%
per annum. Much of this went to finance the expanding deficit. But
on the other hand, the severe depression of those two years increased
the demand for money (i.e., lowered the desire to spend money on
goods) in response to the severe business losses. This temporarily
compensating increase in the demand for money does not make deficits
any less inflationary. In fact, as recovery proceeds, spending picked
up and the demand for money fell, and the spending of the new money
accelerated inflation.

Myth 2:
Deficits do not have a crowding-out effect on private investment.

In recent years
there has been an understandable worry over the low rate of saving
and investment in the United States. One worry is that the enormous
federal deficits will divert savings to unproductive government
spending and thereby crowd out productive investment, generating
ever-greater long-run problems in advancing or even maintaining
the living standards of the public.

Some policymakers
once again attempted to rebut this charge by statistics. In 1982–83,
they declare deficits were high and increasing while interest rates
fell, thereby indicating that deficits have no crowding-out effect.

This argument
once again shows the fallacy of trying to refute logic with statistics.
Interest rates fell because of the drop of business borrowing in
a recession. "Real" interest rates (interest rates minus
the inflation rate) stayed unprecedentedly high, however –
partly because most of us expect renewed inflation, partly because
of the crowding-out effect. In any case, statistics cannot refute
logic; and logic tells us that if savings go into government bonds,
there will necessarily be less savings available for productive
investment than there would have been, and interest rates will be
higher than they would have been without the deficits. If deficits
are financed by the public, then this diversion of savings into
government projects is direct and palpable. If the deficits are
financed by bank inflation, then the diversion is indirect, the
crowding-out now taking place by the new money "printed"
by the government competing for resources with old money saved by
the public.

Milton Friedman
tries to rebut the crowding-out effect of deficits by claiming that
all government spending, not just deficits, equally crowds out private
savings and investment. It is true that money siphoned off by taxes
could also have gone into private savings and investment. But deficits
have a far greater crowding-out effect than overall spending, since
deficits financed by the public obviously tap savings and savings
alone, whereas taxes reduce the public’s consumption as well as

Thus, deficits,
whichever way you look at them, cause grave economic problems. If
they are financed by the banking system, they are inflationary.
But even if they are financed by the public, they will still cause
severe crowding-out effects, diverting much-needed savings from
productive private investment to wasteful government projects. And,
furthermore, the greater the deficits the greater the permanent
income tax burden on the American people to pay for the mounting
interest payments, a problem aggravated by the high interest rates
brought about by inflationary deficits.

Myth 3:
Tax increases are a cure for deficits.

Those people
who are properly worried about the deficit unfortunately offer an
unacceptable solution: increasing taxes. Curing deficits by raising
taxes is equivalent to curing someone’s bronchitis by shooting him.
The "cure" is far worse than the disease.

One reason,
as many critics have pointed out, is that raising taxes simply gives
the government more money, and so the politicians and bureaucrats
are likely to react by raising expenditures still further. Parkinson
said it all in his famous "Law": "Expenditures rise
to meet income." If the government is willing to have, say,
a 20% deficit, it will handle high revenues by raising spending
still more to maintain the same proportion of deficit.

But even apart
from this shrewd judgment in political psychology, why should anyone
believe that a tax is better than a higher price? It is true that
inflation is a form of taxation, in which the government and other
early receivers of new money are able to expropriate the members
of the public whose income rises later in the process of inflation.
But, at least with inflation, people are still reaping some of the
benefits of exchange. If bread rises to $10 a loaf, this is unfortunate,
but at least you can still eat the bread. But if taxes
go up, your money is expropriated for the benefit of politicians
and bureaucrats, and you are left with no service or benefit. The
only result is that the producers’ money is confiscated for the
benefit of a bureaucracy that adds insult to injury by using part
of that confiscated money to push the public around.

No, the only
sound cure for deficits is a simple but virtually unmentioned one:
cut the federal budget. How and where? Anywhere and everywhere.

Myth 4:
Every time the Fed tightens the money supply, interest rates
rise (or fall); every time the Fed expands the money supply, interest
rates rise (or fall).

The financial
press now knows enough economics to watch weekly money supply figures
like hawks; but they inevitably interpret these figures in a chaotic
fashion. If the money supply rises, this is interpreted as lowering
interest rates and inflationary; it is also interpreted, often in
the very same article, as raising interest rates. And vice versa.
If the Fed tightens the growth of money, it is interpreted as both
raising interest rates and lowering them. Sometimes it seems that
all Fed actions, no matter how contradictory, must result in raising
interest rates. Clearly something is very wrong here.

The problem
is that, as in the case of price levels, there are several causal
factors operating on interest rates and in different directions.
If the Fed expands the money supply, it does so by generating more
bank reserves and thereby expanding the supply of bank credit and
bank deposits. The expansion of credit necessarily means an increased
supply in the credit market and hence a lowering of the price of
credit, or the rate of interest. On the other hand, if the Fed restricts
the supply of credit and the growth of the money supply, this means
that the supply in the credit market declines, and this should mean
a rise in interest rates.

this is precisely what happens in the first decade or two of chronic
inflation. Fed expansion lowers interest rates; Fed tightening raises
them. But after this period, the public and the market begin to
catch on to what is happening. They begin to realize that inflation
is chronic because of the systemic expansion of the money supply.
When they realize this fact of life, they will also realize that
inflation wipes out the creditor for the benefit of the debtor.
Thus, if someone grants a loan at five percent for one year, and
there is seven percent inflation for that year, the creditor loses,
not gains. He loses two percent, since he gets paid back in dollars
that are now worth seven percent less in purchasing power. Correspondingly,
the debtor gains by inflation. As creditors begin to catch on, they
place an inflation premium on the interest rate, and debtors will
be willing to pay it. Hence, in the long run anything which fuels
the expectations of inflation will raise inflation premiums on interest
rates; and anything which dampens those expectations will lower
those premiums. Therefore, a Fed tightening will now tend to dampen
inflationary expectations and lower interest rates; a Fed expansion
will whip up those expectations again and raise them. There are
two, opposite causal chains at work. And so Fed expansion or contraction
can either raise or lower interest rates, depending on which causal
chain is stronger.

Which will
be stronger? There is no way to know for sure. In the early decades
of inflation, there is no inflation premium; in the later decades,
such as we are now in, there is. The relative strength and reaction
times depend on the subjective expectations of the public, and these
cannot be forecast with certainty. And this is one reason why economic
forecasts can never be made with certainty.

Myth 5:
Economists, using charts or high-speed computer models, can accurately
forecast the future.

The problem
of forecasting interest rates illustrates the pitfalls of forecasting
in general. People are contrary cusses whose behavior, thank goodness,
cannot be forecast precisely in advance. Their values, ideas, expectations,
and knowledge change all the time, and change in an unpredictable
manner. What economist, for example, could have forecast (or did
forecast) the Cabbage Patch Kid craze of the Christmas season of
1983? Every economic quantity, every price, purchase, or income
figure is the embodiment of thousands, even millions, of unpredictable
choices by individuals.

Many studies,
formal and informal, have been made of the record of forecasting
by economists, and it has been consistently abysmal. Forecasters
often complain that they can do well enough as long as current trends
continue; what they have difficulty in doing is catching changes
in trend. But of course there is no trick in extrapolating current
trends into the near future. You don’t need sophisticated computer
models for that; you can do it better and far more cheaply by using
a ruler. The real trick is precisely to forecast when and how trends
will change, and forecasters have been notoriously bad at that.
No economist forecast the depth of the 1981–82 depression,
and none predicted the strength of the 1983 boom.

The next time
you are swayed by the jargon or seeming expertise of the economic
forecaster, ask yourself this question: If he can really predict
the future so well, why is he wasting his time putting out
newsletters or doing consulting when he himself could be making
trillions of dollars in the stock and commodity markets?

Myth 6:
There is a tradeoff between unemployment and inflation.

Every time
someone calls for the government to abandon its inflationary policies,
establishment economists and politicians warn that the result can
only be severe unemployment. We are trapped, therefore, into playing
off inflation against high unemployment, and become persuaded that
we must therefore accept some of both.

This doctrine
is the fallback position for Keynesians. Originally, the Keynesians
promised us that by manipulating and fine-tuning deficits and government
spending, they could and would bring us permanent prosperity and
full employment without inflation. Then, when inflation became chronic
and ever greater, they changed their tune to warn of the alleged
tradeoff, so as to weaken any possible pressure upon the government
to stop its inflationary creation of new money.

The tradeoff
doctrine is based on the alleged "Phillips curve," a curve
invented many years ago by the British economist A.W. Phillips.
Phillips correlated wage rate increases with unemployment, and claimed
that the two move inversely: the higher the increases in wage rates,
the lower the unemployment. On its face, this is a peculiar doctrine,
since it flies in the face of logical, commonsense theory. Theory
tells us that the higher the wage rates, the greater the unemployment,
and vice versa. If everyone went to their employer tomorrow and
insisted on double or triple the wage rate, many of us would be
promptly out of a job. Yet this bizarre finding was accepted as
gospel by the Keynesian economic establishment.

By now, it
should be clear that this statistical finding violates the facts
as well as logical theory. For during the 1950s, inflation was only
about one to two percent per year, and unemployment hovered around
three or four percent, whereas later unemployment ranged between
eight and 11%, and inflation between five and 13 %. In the last
two or three decades, in short, both inflation and
unemployment have increased sharply and severely. If anything, we
have had a reverse Phillips curve. There has been anything but an
inflation- unemployment tradeoff.

But ideologues
seldom give way to the facts, even as they continually claim to
"test" their theories by Facts. To save the concept, they
have simply concluded that the Phillips curve still remains as an
inflation-unemployment tradeoff, except that the curve has unaccountably
"shifted" to a new set of alleged tradeoffs. On this sort
of mind-set, of course, no one could ever refute any theory.

In fact, current
inflation, even if it reduces unemployment in the short-run by inducing
prices to spurt ahead of wage rates (thereby reducing real
wage rates), will only create more unemployment in the long run.
Eventually, wage rates catch up with inflation, and inflation brings
recession and unemployment inevitably in its wake. After more than
two decades of inflation, we are now living in that "long run."

Myth 7:
Deflation – falling prices – is unthinkable, and would
cause a catastrophic depression.

The public
memory is short. We forget that, from the beginning of the Industrial
Revolution in the mid-18th century until the beginning of World
War II, prices generally went down, year after year. That’s because
continually increasing productivity and output of goods generated
by free markets caused prices to fall. There was no depression,
however, because costs fell along with selling prices. Usually,
wage rates remained constant while the cost of living fell, so that
"real" wages, or everyone’s standard of living, rose steadily.

Virtually the
only time when prices rose over those two centuries were periods
of war (War of 1812, Civil War, World War I), when the warring governments
inflated the money supply so heavily to pay for the war as to more
than offset continuing gains in productivity.

We can see
how free-market capitalism, unburdened by governmental or central
bank inflation, works if we look at what has happened in the last
few years to the prices of computers. Even a simple computer used
to be enormous, costing millions of dollars. Now, in a remarkable
surge of productivity brought about by the microchip revolution,
computers are falling in price even as I write. Computer firms are
successful despite the falling prices because their costs have been
falling, and productivity rising. In fact, these falling costs and
prices have enabled them to tap a mass-market characteristic of
the dynamic growth of free-market capitalism. "Deflation"
has brought no disaster to this industry.

The same is
true of other high-growth industries, such a electronic calculators,
plastics, TV sets, and VCRs. Deflation, far from bringing catastrophe,
is the hallmark of sound and dynamic economic growth.

Myth 8:
The best tax is a "flat" income tax, proportionate to
income across the board, with no exemptions or deductions.

It is usually
added by flat-tax proponents, that eliminating such exemptions would
enable the federal government to cut the current tax rate substantially.

But this view
assumes, for one thing, that present deductions from the income
tax are immoral subsidies or "loopholes" that should be
closed for the benefit of all. A deduction or exemption is only
a "loophole" if you assume that the government owns 100%
of everyone’s income and that allowing some of that income to remain
untaxed constitutes an irritating "loophole." Allowing
someone to keep some of his own income is neither a loophole nor
a subsidy. Lowering the overall tax by abolishing deductions for
medical care, for interest payments, or for uninsured losses, is
simply lowering the taxes of one set of people (those that have
little interest to pay, or medical expenses, or uninsured losses)
at the expense of raising them for those who have incurred such

There is furthermore
neither any guarantee nor even likelihood that, once the exemptions
and deductions are safely out of the way, the government would keep
its tax rate at the lower level. Looking at the record of governments,
past and present, there is every reason to assume that more of our
money would be taken by the government as it raised the tax rate
back up (at least) to the old level, with a consequently greater
overall drain from the producers to the bureaucracy.

It is supposed
that the tax system should be analogous to roughly that of pricing
or incomes on the market. But market pricing is not proportional
to incomes. It would be a peculiar world, for example, if Rockefeller
were forced to pay $1,000 for a loaf of bread – that is, a
payment proportionate to his income relative to the average man.
That would mean a world in which equality of incomes was enforced
in a particularly bizarre and inefficient manner. If a tax were
levied like a market price, it would be equal to every "customer,"
not proportionate to each customer’s income.

Myth 9:
An income tax cut helps everyone; not only the taxpayer but
also the government will benefit, since tax revenues will rise when
the rate is cut.

This is the
so-called "Laffer curve," set forth by California economist
Arthur Laffer. It was advanced as a means of allowing politicians
to square the circle; to come out for tax cuts, keeping spending
at the current level, and balance the budget all at the same time.
In that way, the public would enjoy its tax cut, be happy at the
balanced budget, and still receive the same level of subsidies from
the government.

It is true
that if tax rates are 99%, and they are cut to 95%, tax revenue
will go up. But there is no reason to assume such simple connections
at any other time. In fact, this relationship works much better
for a local excise tax than for a national income tax. A few years
ago, the government of the District of Columbia decided to procure
some revenue by sharply raising the District’s gasoline tax. But,
then, drivers could simply nip over the border to Virginia or Maryland
and fill up at a much cheaper price. D.C. gasoline tax revenues
fell, and much to the chagrin and confusion of D.C. bureaucrats,
they had to repeal the tax.

But this is
not likely to happen with the income tax. People are not going to
stop working or leave the country because of a relatively small
tax hike, or do the reverse because of a tax cut.

There are some
other problems with the Laffer curve. The amount of time it is supposed
to take for the Laffer effect to work is never specified. But still
more important: Laffer assumes that what all of us want is to maximize
tax revenue to the government. If – a big if – we are
really at the upper half of the Laffer Curve, we should then all
want to set tax rates at that "optimum" point. But why?
Why should it be the objective of every one of us to maximize government
revenue? To push to the maximum, in short, the share of private
product that gets siphoned off to the activities of government?
I should think we would be more interested in minimizing government
revenue by pushing tax rates far, far below whatever the Laffer
Optimum might happen to be.

Myth 10:
Imports from countries where labor is cheap cause unemployment
in the United States.

One of the
many problems with this doctrine is that it ignores the question:
why are wages low in a foreign country and high in the United States?
It starts with these wage rates as ultimate givens, and doesn’t
pursue the question why they are what they are. Basically, they
are high in the United States because labor productivity is high
– because workers here are aided by large amounts of technologically
advanced capital equipment. Wage rates are low in many foreign countries
because capital equipment is small and technologically primitive.
Unaided by much capital, worker productivity is far lower than in
the United States. Wage rates in every country are determined by
the productivity of the workers in that country. Hence, high wages
in the United States are not a standing threat to American prosperity;
they are the result of that prosperity.

But what of
certain industries in the U.S. that complain loudly and chronically
about the "unfair" competition of products from low-wage
countries? Here, we must realize that wages in each country are
interconnected from one industry and occupation and region to another.
All workers compete with each other, and if wages in industry A
are far lower than in other industries, workers – spearheaded
by young workers starting their careers – would leave or refuse
to enter industry A and move to other firms or industries where
the wage rate is higher.

Wages in the
complaining industries, then, are high because they have been bid
high by all industries in the United States. If the steel or textile
industries in the United States find it difficult to compete with
their counterparts abroad, it is not because foreign firms are paying
low wages, but because other American industries have bid up American
wage rates to such a high level that steel and textile cannot afford
to pay. In short, what’s really happening is that steel, textile,
and other such firms are using labor inefficiently as compared to
other American industries. Tariffs or import quotas to keep inefficient
firms or industries in operation hurt everyone, in every country,
who is not in that industry. They injure all American consumers
by keeping up prices, keeping down quality and competition, and
distorting production. A tariff or an import quota is equivalent
to chopping up a railroad or destroying an airline for its point
is to make international transportation artificially expensive.

Tariffs and
import quotas also injure other, efficient American industries by
tying up resources that would otherwise move to more efficient uses.
And, in the long run, the tariffs and quotas, like any sort of monopoly
privilege conferred by government, are no bonanza even for the firms
being protected and subsidized. For, as we have seen in the cases
of railroads and airlines, industries enjoying government monopoly
(whether through tariffs or regulation) eventually become so inefficient
that they lose money anyway, and can only call for more and more
bailouts, for a perpetual expanding privileged shelter from free

N. Rothbard

(1926–1995) was dean of the Austrian School, founder of modern
libertarianism, and chief academic officer of the Mises
. He was also editor – with Lew Rockwell –
of The
Rothbard-Rockwell Report
and appointed Lew as his executor. See
Murray’s books.

Best of Murray Rothbard

Email Print