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Thinking About America's Socialist Revival

By Paul Hoffmeister

Last Month in Mississippi, the GOP lost a historically sound Republican House seat as Greg Davis lost by eight points to Travis Childers despite large investments, including a last-minute fund-raiser by Vice President Cheney. With Denny Hastert and Richard Baker's retirements, the GOP has now lost three House seats this year in special elections. The loss is certainly a cause for concern for Republicans as it expands the Democratic majority in the House to 236-199 and recasts Mississippi as potentially a swing state, even though it has been a red state since Ronald Reagan ran in 1980.

In reaction to the Childers victory, Representative Tom Cole, Chairman of the National Republican Congressional Committee, which is tasked with winning these elections, said "a large section of the American people has lost confidence in the Republican Party." He confesses that the party must ask, "Is there something wrong with our product?" Retiring Republican Tom Davis describes today's atmosphere as "the worst since Watergate and far more toxic than the fall of 2006."

Indeed, with the November 2006 election and the increasing threats to GOP House and Senate seats, there is a tectonic shift underway in American politics from the Republican Party to the Democratic. Voters are signaling an increased preference for redistributive, socialist measures that include raising income taxes on the wealthiest, expanding governmental healthcare provisions, increased food stamp programs and even tax credits for non-tax payers. The traditional, free-market brand of the Republican Party, which generally stresses the virtues of the market economy and restraining the expansion of the social safety net and the resultant increase in government expenditures, has fallen into disfavor with the electorate. What's happening?

Drawing from the late political economist Jude Wanniski, this competition between capitalist and socialist economic systems is nothing new or surprising, and is as old as representative democracy itself.[1] Voters are constantly declaring their preference between the two. Simply put, when good capitalism goes bad, voters choose good socialism. One must accept that while good capitalism is superior to the best socialism, good socialism can be better than really bad capitalism.

A properly functioning socialist system allocates resources through a central plan in most part by bureaucrats chosen by the people. It is often preferable over a capitalist system where its political class scours to justify rising unemployment, declining standards of living and the social repercussions that ensue during periods of economic malaise, such as divorce, crime and mental illnesses including depression.

Modern capitalism has evolved into a highly sophisticated mechanism that disperses large and liquid pools of capital - surplus time, energy and talent - for claims on the future production of others. Modern mechanisms of the market such as banks, stock and bond markets and other allocators continuously and automatically calculate returns on investment (ROI) for the extension of capital. The market, true to its calculating and dispassionate nature, will cease to extend capital when ROI becomes persistently negative. It is at this point that if a nation's ruling class has failed to protect its capitalist economic system, the electorate turns to socialism. In other words, when a capitalist market mechanism ceases to accept risks to finance production that facilitates the exchange of goods and services between economic actors, the electorate opts for government to absorb those risks and to assist it in its pursuit for self-survival. What else would one expect from voters when a capitalist system devolves to a point where declining capital formation and standards of living no longer can provide for them?

The capitalist system today is deteriorating for two primary reasons: the depreciating dollar and rising real tax rates on capital. The United States is experiencing a mild form of stagflation last seen during the 1970s.

The modern exchange economy no longer relies on barter to exchange surplus capital and has instead evolved to using currency. The dollar represents a portion of a person's surplus capital that can be traded for another's. For example, a lawyer whose time has been determined by the marketplace to be worth $500/hour may trade a half hour of that for a $250 enjoyable dinner with his wife. But instead of the restaurateur and lawyer bartering champagne and caviar for a half hour consult, the two parties exchange currency representative of the fruits of their labor.

In order for the highly complex capitalist system to function efficiently, the countless currency transactions taking place everyday must be based on sound money that does not change in value so as to preserve the terms of trade between economic actors. These fluctuations in value increase risks to doing business. If the restaurateur takes the lawyer's $250 and deposits it into a checking account to pay for new ingredients next month, but then finds that food and spirit costs have risen 5%, he realizes a 5% loss on that previous $250 transaction. Though prices should fluctuate to provide signals by the marketplace for the appropriate allocation of resources, the price changes witnessed in recent years are not indicative of natural price signals but, instead, the devaluation of the dollar.

It takes more paper money today to buy goods and services, and the problem is worsening. This is confirmed by the rising price of gold in recent years. In 2003, it cost an individual $300 dollars to purchase an ounce of gold, whereas today it costs $850. Because the purchasing power of gold holds over time better than anything, it is the dollar that is losing value, not gold, which in turn as the restaurateur realized, creates inefficient price signals in the marketplace and raises the cost of doing business. In other words, inflation lowers the ROI on commerce and thus deters the willingness to take risks to produce.

Gallup polls indicate that the GOP's popularity is highly correlated with the price of gold since 2000. If one ignores the party's ratings around September 2001 during a period of broad unity in a time of crisis, the GOP's popularity has steadily declined from roughly 50% in 2000 when gold traded at $275, to 40% in early 2005 when gold traded near $425, and now to an astonishing 18% as gold trades around $850. Interestingly, Gallup statistics indicate that this decline accelerated after 2005 as gold's ascent accelerated, breaching a benign $425 level to what are now levels signaling inflation. Of course, the rise in oil, food and mostly all commodities - the living costs greatly affecting consumers - have risen in tandem with gold, as the classical Law of One Price would predict.

The capital gains tax is the most important tax in existence because it directly bears on ROI. Because cap gains taxes are a direct confiscation of successful risk-taking, its existence is always counter-productive, and therefore its optimal rate is always nothing more than zero. Making matters worse, when cap gains taxes are un-indexed for inflation, inflation can make risk-taking increasingly prohibitive. As the dollar continues to depreciate today, inflation is worsening.

According to the Department of Labor, year-over-year CPI is running at 3.9%. For purposes of illustration, this seemingly "low" inflation rate has raised today's un-indexed 15% statutory tax rate on 3-year investments to a nearly 26% effective tax rate. Though it is generally assumed that only representatives of the people in Congress have the power to tax, the Federal Reserve's mismanagement of the dollar is directly raising taxes on capital as well as other segments of the tax structure that are not optimally indexed. What is worrisome is the fact that the recent decline in the value of the dollar represented by sky-rocketing gold and commodity prices, foreshadows an annual inflation rate in the range of 5.5% to 6.5% during the next ten to fifteen years, which could raise the real, effective long-term cap gains tax rate to as high as 32%. These rising tax rates on capital directly reduce the return on investment of capital throughout much of the "above-ground" economy, thus reducing the deployment of capital to productive enterprise that benefits the nation's standard of living.

The lost confidence in the Republicans that Congressman Cole cited this week is a consequence of the party's platform to maintain the status quo of a capitalist system where risks to doing business and declining returns on investment are reducing the American standard of living. It is now perceived as the Party of Chaos. The Democratic Party, on the other hand, represents an expanded governmental role to support risk-taking and provide a backstop if the misfortunes of the cold and mechanical capitalist system put someone down on his luck. The voters, in order to reduce risks to their capital, have no better choice than increased socialism when unfavorable tax and unpredictable monetary conditions reduce returns on investment.

It is important to note that as a presidential candidate Hillary Clinton was very careful to not sound too tough on capital taxation. She would have raised the cap gains tax rate from 15% to 20%, "if at all." Even Barrack Obama has recently back-tracked on initial statements to reinstate the old 28% rate.

Obama, though, just squeaked by Clinton in the Democratic primaries, arguably because of his more dovish foreign policy positions. This may be the Democratic Party signaling that it deems a relatively harder-line foreign policy as increasing the risks of expensive military engagements, which may not be an efficient allocation of the nation's resources. Indeed, Obama has been unabashed in criticizing President Bush and the GOP for spending billions in Iraq rather than in America's inner-cities.

But should the Republican Party kneel to the emerging socialist tendencies of the voters? No. History has proven that good capitalism is superior to good socialism, and thus the GOP must repair the capitalist system by advocating a monetary policy whose objective is stable, sound money. Additionally, it should seek the abolishment of tax penalties on successful risk-taking, i.e. the capital gains tax. The Republican Party should also consider undoing several statutory constraints to risk-taking, including the bankruptcy laws of 2005 as a gesture of goodwill to the American people, signaling that it understands the capitalist system is cold and mechanical, and that the party wants an individual to be better able to more easily start over after failing. After all, the fact that there is no growth without risk-taking means that failure is not only inevitable for some but an accepted outcome. As the lobbying in 2005 confirmed, it is in big businesses' interest to support strict bankruptcy laws because they reduce entrepreneurship and competition. But these are the hallmarks of a successful and efficient capitalist system.

This new policy approach - addressing the monetary, fiscal and regulatory policy realms - would immediately help to improve the capitalist system, increase returns on invested capital, spur productive risk-taking, increase employment, raise wages as labor becomes scarce and bid up in value, and reduce poverty and the chances thereof. The resurging prosperity would allow, as with Tom Brokaw's Greatest Generation, the emergence of one bread-winner households. Furthermore, the dramatic increase in capital formation due to increased ROI would reduce the number of jobs devoted to dealing with economic volatility and social pathologies.

There are segments of the Republican Party advocating smart policy. Congressman Mike Pence has been supporting legislation to index capital gains for inflation, while colleague Paul Ryan is pushing to repeal the Humphrey Hawkins Act of 1978, which is used to justify the Federal Reserve's practice of manipulating interest rates and economic growth to fulfill its dual mandate to maintain low inflation and high employment. A commodity price rule, i.e. the Federal Reserve targeting a stable dollar-gold price, however, is the best course for maximizing employment and keeping inflation low. But the views of Pence and Ryan are not representative of the Republican establishment at-large.

Stable money and low tax rates, though, are not always enough to maintain a properly functioning capitalist system. These are simply today's most important maladies. Capital gains tax rates were low and money was sound in the late 1920's before the Great Depression. But during that experience, the ruling elite seized a chance to increase profits with protective tariffs. The ROI on international trade quickly turned negative as the U.S. and its trading partners raised tariff barriers; and the capitalist system began to break down and living standards dropped sharply. Of course, this breakdown caused the electorate to opt for the social safety net provided by the New Deal when alternatives advocating sound capitalist policies were not offered by the Hooverite Republicans.

If the Republican Party can acknowledge that there is something wrong with their product and convincingly respond to the failures of today's capitalist system, the electorate will always opt for good capitalism and reinstall the party to power. The Republican Party would restore itself as the guardian of an efficient, prosperous capitalist system. Voters just need that option at the voting booth.

[1] Jude Wanniski, "An Essay on Economic Growth," The Brown Economic Review (Spring 1999), 7-10.

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