Wealth Tax: Both Left and Right Have It Wrong.

Today on CNBC (video above) and in an earlier piece in the Financial Times (here), Edmund Phelps presented a new and interesting view of financial crises. Phelps was specifically talking about the current EU Sovereign Debt Crisis but I also would argue that it is applicable to the entire late-2000 Financial Crisis.
I've simplified Phelps' argument in the causal diagram above. First consider the two negative feedback loops in the lower part of the graph that describe long-cycles in the economy (start reading on the bottom). In the outer loop, described explicitly by Phelps, economic growth increases income inequality (wealth) which reduces productivity (why work when you're wealthy) and thus decreases growth. I have added another loop to Phelps' argument, a loop I have talked about in more detail in an earlier post (here), and that is the effect of inequality on directly generating financial crises. To simplify, rich people have a lot of excess income seeking high rents in risky places. When the financial house of cards collapses, the effects on growth are negative.

Now, here is the interesting argument from Phelps. Before the financial crisis hits, the government needs to "unlock" the unproductive wealth and put the money to work through a wealth tax. Let's assume for the moment that the government knows what to do with that wealth in terms of improving the physical and social infrastructure that is undervalued by the private market (rather than using it, for example, to fight a foreign war).

Phelps' argument suggests that both the right and the left have it wrong. The right-wing home remedy for any crisis is to reduce taxes. This just makes matters worse because it increases inequality and locks up more wealth (since there is no aggregate demand, the surplus funds are saved rather than invested in productive activity that might create jobs).

The left also has it wrong when relying on deficit spending. As Keynesian economics argues, during a crisis it is necessary to increase government expenditure to make up for shortfalls in aggregate demand. Unfortunately what happens is that increasing the deficit increases borrowing costs which starts the deficit hawks clamoring for a reduction in government expenditure (they are usually successful as they were in the Recession of 1937-1938 in the US). Increases in the deficit can, at the same time (potentially) create the conditions for future inflation.

The shortcoming in Keynesian theory in my view (you can read Phelps' view here) has always been that it didn't really offer an explanation for why crises occur in the first place. It just offered a policy response that didn't make things worse by contracting aggregate demand further. Phelps seems to offer a better explanation of why crises occur in the first place and a policy response for preventing the development of a crisis in the first place. You can access more of Edmund Phelps academic work, if you're interested, from his website at http://www.columbia.edu/~esp2/.