Credibility

This is a funny book. I haven't read it, but the cover is so hilarious that the rest of the book has to be[1]. It’s easy with hind-sight, but I can’t imagine how this could have ever been a reasonable theory.

The only way for the Dow to reach 36,000 in the time the authors gave (closer to 36,000 than 10,000 by 2010) would be if the economy was about to experience explosive growth or a massive bubble the developed world has, still, never seen. The Dow currently stands between 13,000 - 14,000[2]. The book was written in 1999; the authors were arguing that stocks were cheap at precisely the time they were overvalued due to the dot-com bubble. 

A common measure of stock valuation is the Price to Earnings (P/E) ratio. It is the price of a share over the annual earnings one would receive from owning the share[3]. A high P/E ratio means either profits will increase in the future or there is a bubble. As the graph below shows, the long run average P/E ratio is around 16.

At the end of 1999 the P/E ratio for the S&P 500 was around 30, for the Dow it was around 27. On top of that record setting overvaluation the authors thought stocks could only go up.

I bring this up because one of the authors, Kevin Hassett, is now a Romney adviser, and recently criticized the Tax Policy Center (TPC) for explaining[4] that Romney’s tax plan would result in a higher tax burden for the poor and middle class, and a much lower tax burden for the rich. For some reason, I just don't trust him to be correct.

Dr. Hassett’s criticism is that the TPC did not consider that lowering taxes will boost growth leading to higher incomes and higher tax revenue. It is the same theory that didn’t work for Regan or Bush. The criticism is not only false, but the extent to which Hassett takes this argument has no economic foundation. As the TPC points out: “even when we try to make the plan as progressive as possible... even with implausibly large growth effects, revenue neutrality would likely result in a net tax increase for lower- and middle-income households”. 

It seems Hassett’s true complaint is that the TPC just doesn’t believe hard enough in the always good always growth inducing effects of tax cuts to depart far enough from growth estimates with an empirical foundation. Believing hard enough is how the Heritage Foundation was able to give plainly manipulated biased results showing Paul Ryan’s[5] (now Romney’s VP candidate) budget plan would reduce the deficit and increase growth with no mal-effects. 

After Hassett’s statements, a Romney spokeswoman stated “we are not proposing to ensure revenue neutrality solely through base broadening”. Finally an honest answer, it’s not that the TPC study is flawed, it’s that Romney wants to give more tax breaks to the rich at the expense of the deficit.

This being said the basic idea of Romney’s tax plan is what we need: less tax deductions and loopholes in exchange for lower broader rates that keep effective tax rates from rising. This will distort economic incentives less, make the tax system more efficient, and easier to comply with. Romney takes a good idea and ruins it when he adds the Republican platform of lower taxes for the rich always.

1. Also how could this investment advice fill up a book? If the Dow was going to rise to such high levels the advice to make a profit would be: buy stocks on the Dow Jones Industrial Average. What other strategy for "profiting from the coming rise in the stock market" could there be but buying stocks? Furthermore, the basics of the stock market hold that if enough people expect stocks to rise in the future they inevitably will not, because people will buy the stocks in anticipation and they will rise to the level expected in the future in the present.

2. At the time of writing, the Dow's all time nominal high was 14,164.53 in October 2007.

3. Another way to think of the P/E ratio is the number of years it takes to make back the money you paid for the stock.

4. Full version of TPC study can be found here.

5. If you're interested in reading just how horrible Paul Ryan's budgets/knowledge of economics is, University of Madison Professor Menzie Chinn has been following his fellow Wisconsinite's record and provides a useful archive here.