I, Double-Digit Inflation, being of sound mind but failing body, do solemnly declare the following to be my last will and testament. To the economy of the United States of America, I leave the following:
FIRST, a transformation of the financial system for which I supplied the impetus, and whose effects are likely to be both permanent and highly beneficial.
The high and variable interest rates which I caused spurred the financial system to devise new ways of making payments and new vehicles for saving. Businesses improved their cash management techniques, discovered repurchase agreements, and learned more and more ways to get along with less and less cash. Consumers now have available to them new types of bank deposits, money market funds, and sweep accounts which enable them to earn market rates of interest on their savings. Even conventional checking accounts now pay interest.
Though few people love me for it, I paved the way for all these innovations by forcing the government to reduce financial regulation and by pushing banks and other financial institutions out of their lethargy. Even as I peter out, the transformation of the financial system continues. It will stand as one of my enduring achievements.
High Real Interest Rates
SECOND, I leave millions of consumers and business firms saddled with an onerous burden of high real interest rates, a burden they will suffer under for years to come. This is my revenge upon those who treated me with such contempt by refusing to write the indexed contractual arrangements that I so clearly required.
Many firms and households entered into long-term agreements to borrow money on the expectation that I would remain in the double-digit range indefinitely. Now that I have shrunk, they find themselves paying real interest rates they never dreamed of. Many will be unable to pay. Already thousands of businesses have been driven into bankruptcy and thousands of mortgages have been foreclosed. More will come. And all because of a stubborn refusal to learn to live with me in peaceful harmony.
In this, I was helped by the Federal Reserve System. What irony! My chief assailant, by using tight money to weaken me, has prevented nominal interest rates from falling even as I wither away. Consequently, real interest rates are at their highest levels in history.
Normally, nominal interest rates fall as inflation subsides. This enables businesses and homeowners who borrowed at high rates to prepay their loans (with only small penalties) and refinance at lower rates.
But the Federal Reserve, in its murderous anti-inflationary zeal, has prevented this from happening. The 16 percent loan rate that was originally comprised of a 4 percent real rate and 12 percent expected inflation now signifies a 10 percent real rate and 6 percent expected inflation. And no one can escape their obligation to pay these ruinous rates by refinancing. How delicious!
The New Corporate Tax Law
THIRD, I leave a ticking time bomb whose existence has even now been recognized by only a few--a pernicious tax law that, in the name of spurring capital formation, will actually undermine the efficiency of the capital market. I am referring, of course, to the Accelerated Cost Recovery System (ACRS) that was enacted in 1981.
For this, I claim some responsibility. Because interest, depreciation, and capital gains are not indexed for tax purposes, I am able to cause enormous changes in the effective tax rates levied on capital. When there is high inflation, heavy taxes are paid on illusory "income" from capital that in fact merely compensates lenders for the losses of purchasing power that I cause. This was true in 1981 and remains true today.
When business complained about the onerous rates of taxation, Congress responded in Pavlovian fashion without showing any understanding of the fact that I was to blame. Instead of introducing indexing, which would have robbed me of the ability to wreak havoc on the tax system, Congress accelerated depreciation allowances far beyond economic realities. While this did reduce businesses taxes, as intended, it also left effective tax rates in my hands, just as they had been before.
So I continue to make mischief. When I grew, I surreptitiously raised the taxes on capital. Now, as I shrink, I reduce them. And people think Congress decides how heavily capital should be taxed!
Few people understand that the present corporate income tax actually represents a subsidy, not a tax, on the typical investment as long as inflation remains at or below 7 percent. By the end of the decade, unless I rise again, the corporate income tax will be bringing negligible revenues to the federal Treasury.
But the "tax" will leave a legacy of economic distortions by subsidizing some types of investments (especially short- lived equipment) while taxing others (such as industrial structures). Since businesses will concentrate on the investments that are accorded the most favorable tax treatment, rather than on those with the highest productivity, the efficiency of the economy will be impaired.
In the name of free-market economics, Congress will have interfered massively in what may be the principal task of a capitalist system--the allocation of capital to the places where it is most productive. What sweet revenge on the supply-side economists who vowed to slay me!