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Economic Debate: Laffer vs. Liesman

Here's the transcript of last night's dynamic economic debate on CNBC's The Kudlow Report between my two good friends — both terribly bright economists — Art Laffer and Steve Liesman. Art is my mentor. Steve is my valued colleague.

LARRY KUDLOW: Let me bring in Arthur Laffer, I want to get his take on all this, and a few other things. Art Laffer, the head of Laffer Investments, former Reagan advisor and the co-author of “The End of Prosperity.” So Arthur, let’s have a quick lay of the land here from your perspective.

ARTHUR LAFFER: Yeah, what they’re doing Larry is the government is borrowing all the private capital available in the marketplace, then they’re the only ones left to invest anywhere. And it is, effectively, a partial nationalization of not only the banks, but of the auto industries. It’s a catastrophe. And the market is giving it a huge thumbs down and raspberry on these policies. I’ve never seen anything so bad in my life.

KUDLOW: What about this issue of the forthcoming Geithner plan? The public/private fund that is going to band together and purchase the toxic assets from the banks? Do you give that any credibility? Any efficacy? Will it do any good?

LAFFER: No, I don’t. I really don’t. I mean, everyone agrees with stress tests for banks. I mean that’s clear. But banks should do that on their own. And they should worry about their own capital functioning. That’s what they should do. It shouldn’t be a government function. And how does the government know what it’s going to be in unemployment rates, what the sensitivities are here? That’s something that, on the companies I’m on the boards of, we always do stress testing to see how we can handle bad times. But this is just government coming in and taking it all over. It’s outrageous.

KUDLOW: Steve Liesman, outrageous, that’s one of my favorite adjectives.

STEVE LIESMAN: Let me just say I share Arthur’s skepticism about the government’s ability to do anything here.

KUDLOW: Ohhhh…

LIESMAN: But Arthur…

LAFFER: Yes Steve.

LIESMAN: You have $600 billion of excess reserves in the banking system, on the balance sheet of the Federal Reserve. It is not as if people are clamoring, and lining up out the door for private capital right now. I understand, over a long period of time, there’s a situation where the government could crowd out. But in times when you have the kind of slack we have in the economy, I think it’s sort of, at least conventional economic wisdom, that the government doesn’t crowd out when it invests at this time.

LAFFER: Well it’s conventional economics from this administration, Steve. But frankly that monetary base that they’ve increased by about 150 percent in the last six months is one of the most dangerous, outrageous things I’ve seen. It’s ten times the percentage increase ever before in the US. And banks are making loans. If you look at the M1 data Steve, you can see that bank loans are increasing. They’re increasing very rapidly…

KUDLOW: Across the board. Across the board…

LAFFER: Across the board. And over the last ten years…

LIESMAN: Art, Art, I am your student Art…

KUDLOW: Wait.

LIESMAN: There’s no velocity…

KUDLOW: It’s the breakdown in the securitized secondary markets Arthur.

LAFFER: That’s what it is. That’s exactly what it is…

KUDLOW: The banks are actually doing their jobs. And oddly enough…

LIESMAN: But there’s no velocity Larry. That’s the thing. You can put out there a hundred trillion dollars, if there’s no velocity, there’s no inflationary effect.

LAFFER: But velocity comes later Steve, and then you’re going to get the inflation. The velocity will come.

LIESMAN: But you don’t have [velocity] now. Art, they can pull it back though at that point…

KUDLOW: Let’s talk about this. Hold on. Let me set the stage, this morning Arthur, this morning, on [CNBC’s] The Call with Melissa Francis and me, Steve Liesman and I had a little debate about inflation.

LAFFER: I heard.

KUDLOW: And the causes of inflation. Steve Liesman of course, is a great, famous Keynesian Phillips-curver. He believes that high unemployment reduces inflation, and low unemployment and strong economic growth raises inflation. On the other hand, I represented the monetary school, which says inflation is caused by too much money chasing too few goods. And Steve, as a throwaway said, with inflation and taxes, he’d like to discuss with Arthur Laffer. So I have delivered the aforementioned…

LAFFER: Well I love Steve Liesman, let me just tell you that Larry.

KUDLOW: Steve Liesman and Arthur Laffer. Arthur What is your response to Steve’s…

LIESMAN: He said he likes me Larry. You just talked right over that compliment.

KUDLOW: Actually, we love you. It’s not like, it’s love. It’s deep-seated love and I don’t even need a stress test to find this love.

LAFFER: The Fed can’t pirouette and do this sort of thing Larry. What they’ve done with the monetary base is they’ve set into motion an enormous inflationary pressure in the US economy. With the shrinking of the US economy, and it’s shrinking very rapidly, you not only have more money, but you also have fewer goods. That’s a classic double-whammy on inflation.

KUDLOW: Did you not hear that from me this morning, Mr. Liesman?

LIESMAN: I heard that from you.

KUDLOW: Did I say something that was almost virtually identical, even the same?

LIESMAN: You did. I do not buy the idea that capacity has been so diminished that we have a problem of too few goods. And Art, my whole point is this, is that, this idea of too much money? Absolutely. Doctrinaire. Doctrine. Absolutely. There must be a transmission mechanism. And when you have high unemployment, and you do not have the goods destruction, you maintain globalization, you maintain competition in the economy. Then you have no transmission mechanism for that inflation…

LAFFER: No, no. Steve, Steve. You’re missing one thing here, if I may interject.

LIESMAN: Okay, if it’s just one then I’m in good shape…

LAFFER: Unemployment has to do with the real wage in the system here. What we’re talking about is the price of goods, all goods, in terms of money. That has nothing to do with unemployment, except for the fact that you get fewer goods. And when you have more money and fewer goods, the amount of dollars per good goes up. It goes up because there are fewer goods and it goes up because there is more money. And the monetary base is the number you have to look at.

KUDLOW: All right, bottom line. Monetary base you have to look at.

LAFFER: That’s the one.

KUDLOW: And you should probably have a glance for the use of money from M1 and M2 Arthur, right?

LAFFER: That’s right.

KUDLOW: You buy that too. And by the way, more goods would be available to absorb the excess money. So more goods and more growth would be counter-inflationary. Is that right Art?

LAFFER: Yeah that’s exactly right. But then Larry…

LIESMAN: I agree with that.

LAFFER: But then Larry, the velocity of money is all of a sudden going to start rising…

LIESMAN: We should be so lucky…

LAFFER: Once you see your inflation starting Steve…

LIESMAN: We should be so lucky…

LAFFER: Then you’ll see the velocity soar and you’ll get [inaudible] hyper-inflation…

LIESMAN: Can we just admit that if the money sits on the balance sheet at the Fed, it is not at that moment inflationary?

LAFFER: It’s not sitting on the balance sheet at the Fed, and it is at that moment. That’s where money always sits. The question is how much money sits where and under what demand for money.

KUDLOW: All right, I’ve got to push down. I’ve got to push down. Last point. Steve Liesman wanted to know this morning Art, what is the highest marginal tax rate that would really do damage to the economy? And I want to raise this point, Mr. Obama last evening in his speech, reaffirmed his intention to roll back the Bush tax cuts. So the 33 percent tax rate goes to 36, and the 35 percent tax rate goes to 40. What we learned today Arthur is, he’s going to take steps before the Bush tax cuts expire in 2010. In his current budget, to be released tomorrow, he is going to lower the exemptions for the upper-end people. In other words, a 35 percent tax rate payer cannot deduct 35 percent, for example, of his mortgage interest. He’ll only be able to deduct 28 percent. He’ll only be able to deduct 28 percent from his charitable contributions. Art Laffer, will this hurt the economy? Just the beginning. The lower exemptions and ultimately the higher tax rates?

LAFFER: Well of course it will hurt the economy Larry. But I was watching Nancy Pelosi say that the real revenue raisers that they’re going to have to come to, and they will have to come to this, are the payroll taxes, consumption taxes, and low-income and middle-income income taxes. Sooner or later they’re going to go to that. And they’re going to go really hog wild on raising taxes. And they’re going to do it Steve, and it’s not going to be very far out in the future.

KUDLOW: All right Steve, last word, go ahead.

LIESMAN: I agree if that happens that’s terrible…

KUDLOW: Ask him your question.

LIESMAN: My only point Art that I had Art was this, is that there is no tailor rule for the great concept of the Laffer Curve. So my point is that it is impossible to know where we are on the Laffer Curve at any one point in time such that a 2 or 3 percent rise in the tax rate…

KUDLOW: Five percent, five percent.

LIESMAN: May have little effect or a huge effect.

LAFFER: That’s true, that’s true.

KUDLOW: All right Art, last word real quick.

LAFFER: But so what? We’re not after which tax rates raise revenues, we’re after which tax rates hurt the economy, hurt output, hurt employment and cause inflation. And those tax rates are continuous across the whole range and they’re getting worse and worse and worse every day Steve. It’s frightening.

KUDLOW: All right, hang on. Thank you Steve Liesman. Well done. Art Laffer…

LIESMAN: Can I just thank you for the opportunity to talk to Art Laffer?

LAFFER: Thanks Steve.

LIESMAN: Thank you Art.

KUDLOW: That was great stuff.