The Elephant and the Maharajah

Martin Feldstein
Martin Feldstein; drawing by David Levine

Since presidents tend to choose economic advisers who can be depended on to advise that presidents want to hear, the direction of intellectual influence runs more from president to adviser than from adviser to president. As is usually the case, the president, Mr. Reagan, and the chairman of his Council of Economic Advisers, Martin Feldstein, had similar views long before the two met. But the adviser’s views are still important since they provide the principal filter through which new economic information reaches the president, and they reveal much about what the president wants to hear.

Although technical, this volume of previously published essays written between 1975 and 1981 is a good reflection of Martin Feldstein’s ideas and the resulting filter. The view is simply put in the first paragraph, with the “proof” of it occupying the rest of the book.

The interaction of inflation and existing tax rules has powerful effects on the American economy. Inflation distorts the measurement of profits, of interest payments, and of capital gains. The resulting mismeasurement of capital income has caused a substantial increase in the effective tax rate on the real income from the capital employed in the nonfinancial corporate sector. [I.e., as inflation causes the dollar income of corporations to rise, they pay higher corporate taxes on their real income.] At the same time, the deductibility of nominal interest expenses [from taxes] has encouraged the expansion of consumer debt and stimulated the demand for owner-occupied housing. The net result has been a substantial reduction in the accumulation of capital in nonfinancial corporations.

As a result, Feldstein argues, the American economy is performing poorly and economic policies need to be recast. While admitting that the best solution would be tight fiscal policies (a budget surplus) and easy monetary policies (low interest rates), Feldstein sees this as politically impossible. Congress won’t cut civilian spending. As a result the only feasible “second best” solution “for achieving the dual goals of balanced demand and increased business investment would combine a tightmoney policy and fiscal incentives for investment and saving.”

According to Feldstein tight money will prevent inflation and raise the real rate of interest after taxes. Inflation will be held down by using tight monetary policies to prevent unemployment from falling below what is now a very high “natural” rate of full employment (i.e., the rate of unemployment necessary to prevent inflation from accelerating). Higher real interest rates will deter spending on housing and consumer durables as well as on plant and equipment, but the latter effect is to be more than offset with specific tax incentives for productive investment.

This view is not completely wrong. In relation to the growth in our own labor force, or to our foreign competition, Americans don’t save or invest enough. The problem is that Feldstein makes the error that he attributes to others at the end of his book:

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