STAFF NEWS & ANALYSIS
NY Fed: Tax Cuts May Heighten Deflation Risks
By - February 19, 2009

Cutting taxes to try to stimulate the economy could do more harm than good in a zero interest rate environment as it can heighten the risk of deflation, according to a recent New York Federal Reserve study. Policies that are aimed at increasing the supply of goods can be counterproductive when the main problem is insufficient demand, New York Fed economist Gauti Eggertsson (pictured left) said in a research paper entitled "Can tax cuts deepen the recession?" "The emphasis should be on policies that stimulate spending," Eggertsson said, adding that his research found the impact of tax cuts is "fundamentally different" with interest rates near zero. "At zero short-term nominal interest rates, tax cuts reduce output in a standard New Keynesian (economic) model. They do so because they increase deflationary pressure," he wrote. Eggertsson's study focused primarily on labor taxes and some sales taxes. Cutting payroll taxes, for example, would create an incentive for people to work more. But if there are not enough jobs, this could have a negative effect: creating more demand for work and thus driving down wages. And with interest rates near zero, the Fed cannot cut rates further to fight deflation. – Reuters

Dominant Social Theme: Let's stick to Keynes.

Free-Market Analysis: We have written how the discredited economic theories of John Maynard Keynes have sprung back to life. They are not much good, but unfortunately, they provide adequate theoretical cover for continued government misdeeds; thus, they continue to be in vogue.

Keynes was a socialist economist who moved in high society and was personally and professional ambitious and a facile mathematician. He was of the school, to a degree, of econometrics, the use of numbers to prove out economic predictions. Yet Keynes was wrong. Free-market economics shows us that individual human action will interrupt any trend. To extrapolate human conduct based on what is already known is a fool's errand. Yet still it persists – probably because without such theoretical support, Western governments would not be able to justify huge spending programs – and without big government spending (hidden taxes), central bankers wouldn't have nearly as lucrative a go at it.

Twenty years ago, before the Internet, Keynes was almost universally taught and accepted – probably for the above reason. He was a poster boy for the banking establishment. It could not have been due to the elegance of his thought. Despite the incredible complexity of his texts, the main point that Keynes makes when it comes to the business cycle is that Western recessions are based on a lack of consumer demand. But this incredibly simplistic point does have one advantage: It allows government types to claim that spending money stimulates demand.

But contrast this to the subtle arguments of free-market economics showing that it is the act of over-printing money by central banks that cause market distortions and overly-destructive business cycles. For obvious reasons neither governments nor central banks wish to publicize such a construct. And until the Internet came along, the monetary elite was doing a pretty good job of suppressing free-market economics with one-sided media reporting on issues purposefully delinked from reality. Not anymore.

Do a Google search of one of the fathers of free-market economics, Ludwig von Mises, and you may well find almost half as many mentions as John Maynard Keynes (we did). That's up from almost none – zero – a decade ago. There is no excuse anymore for not grappling with free-market economics and taking the free-market perspective seriously. Yet the American Fed does not seem to do so. Instead, incredibly, it promotes an academic study that is based on easily-discredited Keynesian economics. Coincidence? We have yet to see such a study out of the Fed based on Austrian, or free-market economics.

After Thoughts

There are numerous ways to combat a depressive economy, but printing more money and providing massive government outlays for make-work programs will only aggravate the problem. What works are tax cuts and reducing government spending. What would work even better is a reduction in central banking activity alongside the re-imposition of some sort of honest money standard (gold and silver). There is the impression in some quarters that elements in Western governments want the crisis to drag out and even to be exacerbated. Such rhetoric as the Fed offers via this Keynesian-based study does nothing to disabuse free-market thinkers of such a cynical notion and, in fact, advances it.

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