Where’s The Magic Formula?

(This item originally appeared at Forbes.com on March 3, 2018.)



For some time, I’ve argued that a lot of economic policymaking boils down to the Magic Formula, which is: Low Taxes and Stable Money. There is more to it than this, of course; but if you don’t get the big stuff right, the little stuff won’t matter. So, get the big stuff right, first.

Conversely, when a country runs into trouble, you can usually find that high or rising taxes, unstable money, or both are also present. The analysis usually doesn’t have to go much further. Fix that, and the ship will right itself.

This is not supposed to be a complicated, or surprising idea. Forty years now after the “supply side revolution” in the U.S., and after decades of diligent and detailed work by the American Enterprise Institute, the Heritage Foundation and others in favor of Low Taxes and at least a rude avoidance of monetary disasters, it should be a familiar concept. Every Republican presidential candidate has a tax reform plan, and recently they have been both aggressive and sophisticated. Actually, this was familiar concept two hundred and fifty years ago, too. Adam Smith, writing in 1755, summed it up:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things.

Smith said not only that you should get the big stuff right, but that if you get the big stuff right, the small stuff will more-or-less take care of itself, “all the rest brought about by the natural course of things.”

Smith didn’t have as much to say about Stable Money, but, at the time he was writing, the British pound had been one of the most reliable currencies in Europe, having been essentially unchanged in value for over two hundred years. It probably didn’t seem that pressing. Nevertheless, he devoted the last chapter of The Wealth of Nations to a warning to avoid currency devaluation.

And yet, I’ve noticed that economic intellectuals don’t seem to have much to say about the Magic Formula. Rather than building on Adam Smith’s insight, they seemed to have forgotten it.

Greg Mankiw, a mainstream academic economist, once summed up what his specialty had to offer in the form of ten principles. They were:

  1. People face trade-offs
  2. The cost of something is what you give up to get it
  3. Rational people think at the margin
  4. People respond to incentives
  5. Trade can make everyone better off
  6. Markets are usually a good way to organize economic activity
  7. Governments can sometimes improve market outcomes
  8. A country’s standard of living depends on its ability to produce goods and services
  9. Prices rise when the government prints too much money
  10. Society faces a short-run tradeoff between inflation and unemployment.

Not a word about the Magic Formula. Reading this list, can you describe what beneficial economic policy might be? (You might think that “people respond to incentives” is about taxes, but it’s not.)

Yoram Bauman, a professor of economics at the University of Washington, translated Mankiw’s Ten Principles for laymen:

  1. Choices are bad
  2. Choices are really bad
  3. People are stupid
  4. People aren’t that stupid
  5. Trade can make everyone worse off
  6. Governments are stupid
  7. Governments aren’t that stupid
  8. Blah blah blah
  9. Blah blah blah
  10. Blah blah blah

The Foundation for Economic Education, representing a more libertarian approach, suggested their own twelve principles:

  1. Gains from Trade.
  2. Subjective Value.
  3. Opportunity Cost.
  4. Spontaneous Order.
  5. Incentives.
  6. Comparative Advantage.
  7. Knowledge Problem.
  8. Seen and Unseen.
  9. Rules Matter.
  10. Action is Purposeful.
  11. Civil Society.
  12. Entrepreneurship.

All fine ideas. Not a word about the Magic Formula. Nothing about peace and a “tolerable administration of justice” either.

Let’s go on. Applied Mainline Economics (2017), by Matthew Mitchell and Peter Boettke of the Mercatus Center, is a summary of how to apply the Austrian/libertarian economic principles of the Mercatus Center to practical policy. It has no discussion of either Low Taxes or Stable Money. Boettke’s Living Economics (2012) has one index entry about taxes, which refers to one sentence. Austrian Economics and Public Policy (2016), by Richard Ebeling, has a nice discussion of Stable Money, but again almost nothing about taxes (although he does prefer them to be low and unobtrusive). This mirrors Human Action (1949), by Ludwig von Mises, which has six pages of discussion about taxes out of 900.

Eugene Bohm von Bawerk was a leading light of the “Austrian School,” serving as the Finance Minister of Austria three times between 1895 and 1904. In 1891, he became the head of the tax department of Austria’s Ministry of Finance, and undertook a major reform of both direct and indirect taxation. In 1892, he became the head of a national commission to restore the gold standard in Austria, after a long period of a gently floating currency. This was achieved in 1896. He also wrote a three-volume book, Capital and Interest (1890), as a refutation of Marxism. But, he didn’t seem to have much to say in it about either Low Taxes or Stable Money. In 1913, he admitted: “I have not yet included the theory of money in the subject matter of my thinking …”

In The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor (1998), David Landes concluded that the answer was basically: culture. While this has some truth to it — all of the Anglophone countries have been rich from the start — it doesn’t say much about specific policy. Between 1700 and 1900, Britain consistently had the lowest taxes and most stable money in Europe, and ended up with the largest empire in the great age of European Empire.

In Why Nations Fail: the Origins of Power, Prosperity, and Poverty (2012), Daron Acemoglu and James Robinson claimed that successful countries could attribute their wealth to: democracy. This too has some truth to it. The British parliamentary system, with the Parliament responsible for taxation and the king responsible for spending, kept taxes low for generations. If democracy has any lasting advantage, it is that it leads to better policy, or at least, avoidance and correction of major policy mistakes. But, many countries have been successful without democracy. Hong Kong has never had it, but it became wealthy anyway, with Low Taxes and Stable Money. China has never had democracy in all of its five-thousand-year history, but as early as the fifth century B.C., Confucius insisted that taxes should not exceed 10% of income or production. For 2,500 years afterward, Chinese government officials were required to study his works in detail.

The Ancient Greeks considered any type of direct taxation to be a form of slavery. Except for some short periods during wartime, their silver drachma was unchanged for six centuries. This basic principle too was written into the U.S. Constitution, which effectively disallowed direct taxation until the Sixteenth Amendment was added in 1913. The Constitution also explicitly states that “No State shall … make any thing except gold and silver coin a tender in payment of debts,” and though the letter of this law was never followed (banknotes were common from the start), the United States nevertheless maintained the principle of gold-based money until 1971. The Magic Formula was written in black letters into the supreme law of the land — the summary wisdom of perhaps the greatest group of political thinkers that has ever been assembled anywhere on Earth —  but we can’t quite remember it today.

The IMF informs us that roughly two-thirds of all governments have a policy of linking their currency to an external standard of value, usually either the dollar or euro. There has been too much experience with unstable money, especially since the end of the Bretton Woods gold standard in 1971. The gold standard — the usual practice of responsible governments for centuries before 1971 — was a variant of this basic principle. And yet, hardly any economist today has anything to say about “Stable Money” — what it is, and what it might be good for. They are all money manipulators, whether of the seat-of-the-pants variety or the “rules-based” sort.

Thus, the Magic Formula seems to be something that everyone knows, and that everyone has forgotten. I think we should keep it in mind today.