Paul Ryan Plan or Higher Taxes, Take Your Pick

This week President Barack Obama is offering his plan to solve America's debt problem. The president's approach will include tax increases.

Republicans will huff that the Grand Old Party will never raise taxes. They will tell the president that they want to be like Ronald Reagan or Calvin Coolidge or Andrew Mellon, the Treasury secretary from 1921 to 1932. Mellon, who cut income tax rates to 25 percent from 73 percent in the 1920s, is the tax-cutters' deity. His anti-tax manifesto, "Taxation: The People's Business," is so hot that a first edition sells for $1,250.

What Mellon's admirers overlook is that that those cuts made up only part of his program. Mellon also cut the budget. Several years into the Great Depression experts concerned with widening deficits went to the Treasury Department, demanding tax-rate increases, levies on autos and radios and even a creepy tax on checks.

Did the legendary Treasury secretary tell those wonks to take a hike? He did not. Mellon duly trashed his own legacy and pushed the top tax rate right back up, to 63 percent.

What caused Mellon's humiliating surrender? Timing. By December 1931, it was too late for him to do anything else but raise taxes.

Mellon was trapped by errors made in preceding years, at home and abroad. His own Republican Party had pushed through a nasty tariff, Smoot-Hawley. Investors had pushed stock prices too high. The U.S. was on the gold standard, and people feared that gold and dollars would flow overseas if the U.S. deficit deepened too much.

Dwindling Options

The French were hogging gold at the time. Less gold in the U.S. meant less currency in circulation, and the Great Depression got even worse. Mellon had also tried raising money by selling government bonds, but he believed the bond tool was exhausted. In 1931 Mellon feared the U.S. would lose its status on the world stage if the country couldn't prove it was solvent. That winter's tax increase was his, and the nation's, last worst resort.

Here's what the Mellon story tells us: there comes a point when even the most devoted tax cutter will raise taxes. The trick for the country is to avoid getting to that point. In our own cycle, that point of needing a dramatic tax increase is just years, possibly even months, away.

Time Running Out

There was an era when U.S. politicians had the luxury of ample time, and their motto could be "tax cuts first, deficits second." Another maxim was also popular: "deficits don't matter because we outgrow them." In many instances from the 1960s to the 1990s, tax cuts did indeed promote growth and prevent deficits.

The argument that tax cuts were the one answer for growth was plausible because the U.S. lacked competition. Europe was still divided by multiple currencies. China wasn't yet on the scene. Republicans could tell themselves that even ridiculous tax code changes such as child credits helped the economy. The U.S. economy was doing so well that a Republican who grumbled about the debt looked like an irrelevant Scrooge.

Some Republicans still think this way. Indeed, Republican denial about the damage of deficits neatly parallels Democratic denial about the damage of high wages. Republicans pretend they are living in the 1980s. Democrats pretend they are living in the 1950s. Both parties ignore the fact that international competition has now changed our situation.

Inhibiting Growth

What about today? We all are starving for growth. This week I'll be in Dallas at a conference on economic growth hosted by the new George W. Bush Institute. It's part of the group's ambitious 4% Project, which seeks ways to achieve long-term economic growth of 4 percent.

This time yearly growth in the U.S. can't reach 4 percent, or even 3 percent by tax changes alone. Cuts in debt and entitlement reform are also necessary. The federal debt is too big to outgrow, especially with interest rates heading up. The very structure of our entitlement programs guarantees that greater economic growth will yield larger budgetary shortfalls. The formula for Social Security is pegged to the average real wage. When the economy grows, that wage increases, driving up the government's pension obligations commensurately.

And this time, the competition from China and Europe, in terms of their economies and currencies, will not go away. America's next big financial crisis will be a money crisis. To survive, the dollar will have to demonstrate that it's not based upon ever-widening debt and is worthy of investment by foreigners.

Best Strategy

The best move for anyone of either party who wants even a shot at blocking tax increases before it's too late ought to line up behind House Budget Committee Chairman Paul Ryan like a recruit at basic training.

Ryan's proposal is imperfect, but the plan is at least ready. Critics unhappy with elements of it can add their own changes to the next budget, once unity creates momentum. In short, the U.S. has to show it realizes it is confronting an existential threat. Monetary policy must also change. Arbitrary moves like the Federal Reserve's second round of quantitative easing make the U.S. look unreliable to investors with other options.

This past weekend Ryan said, "we need a clean break" with old history. True enough. But those who can't remember Mellon's past are condemned to repeat it.

Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations and author of "The Forgotten Man: A New History of the Great Depression," is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Amity Shlaes at

To contact the editor responsible for this column: James Greiff at

© Copyright 2011 Bloomberg

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To book Amity Shlaes for a speaking engagement, contact Jamie Brickhouse at the Red Brick Agency, 646.281.9041.
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