1065 and All That

WE have to assume you've got some sort of crystal ball," Democratic Senator William Proxmire of Wisconsin complained last week to George Shultz, director of the Office of Management and Budget. Proxmire could not understand how the Administration justified its projections of a huge rise in the U.S. economy this year. Replied Shultz: "We have a different way" of forecasting. Said Proxmire: "You haven't told us what it is."

If Proxmire had looked to the far end of the witness table at the Joint Economic Committee hearing, he would have seen a squat, tousle-haired economist who is partly responsible for reinforcing the Nixonian optimism. Arthur Laffer, 30, an associate professor on leave from the University of Chicago to serve as the OMB economist, has been in Washington for only three months. Few but Shultz seem convinced that Laffer's analytic methods are correct, but the academician's ideas have nonetheless provided Shultz with a basis to defend the Administration's forecast against doubts voiced by the Council of Economic Advisers.

Averaging Zero. Laffer has constructed a theoretical model of the U.S. economy that he insists is "most likely better than any of the well-known larger models." It is certainly constructed on different lines. Laffer uses only raw economic data; he ignores the seasonal adjustments that more conventional economists prefer because he thinks they "smear things." He also disregards such matters as the likelihood of a steel strike next summer, the prospective size of the federal deficit and the amount of money saved in banks. "These things all averaged out to zero when we tracked their effect [on the overall economy] in the statistics," he says.

Instead, Laffer predicts the behavior of the economy by using only four indicators. One is the level of federal spending. Two others are interest rates and stock prices, which Laffer believes offer "unbiased forecasts" of future inflation and future profits, respectively. His "efficient markets theory" holds that interest rates and stock prices reflect largely the judgment of market insiders who "possess information about the future." This idea might bring hollow laughs from borrowers and investors who have lost money because of the gyrations of interest rates and the stock market.

Christmas Every Month. Laffer's most important indicator is the rate at which the Federal Reserve expands the nation's money supply. That is also Milton Friedman's central idea, but Laffer gives it a special twist: he believes that an increase in money supply gives the economy an "instantaneous and permanent" boost. His reasoning is that businessmen and consumers will immediately spend every cent they get their hands on, and that new money moves speedily into their pockets. "People want to see the color of the money," he says. "When they see it, they jump quick." Laffer thus figures that the U.S. can achieve a G.N.P. of $1,065 billion--or even $1,075 billion--and 6.8% real growth this year with only a 6% increase in money supply, or about what the Federal Reserve seems likely to provide. His forecast is based largely on a calculation that each dollar of growth in money supply adds $4 or $5 to business and consumer spending and therefore lifts the G.N.P. directly and quickly.

Other economists vehemently dispute Laffer's theory of instant reaction to money-supply changes. Most assume that it takes at least six months for an increase to be felt in the economy. Many economists argue that Laffer's theory gets cause and effect backward. In their view, the theory implies that people would spend as much money in, say, July as they do at Christmas and Easter, if the Federal Reserve would only put out as much money as it does during the holiday seasons. Laffer's money machine, quips Economist Arthur Okun, "promises Christmas every month of the year."

Laffer replies simply that figures on past economic activity prove that he is right. His theories are heading for a stern test. If they work, the nation will be well off--but conventional economists will get one of their biggest shocks ever.

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