Supply-Side Economics: Paul Krugman Responds

Via email, Paul Krugman responds to recent posts on supply-side economics. The posts he is responding to are on the continuation page:

OK, here's what I would say:

Let's suppose that it's true that people in DC were still thinking in terms of crude, 1950-vintage vulgar Keynesianism, even while people in Cambridge were thinking in terms of a framework in which money mattered, there was no long-run tradeoff between inflation and unemployment, etc.. Even so, why did you need a doctrine called supply-side economics, which purported to challenge the fundamentals of Keynesian economics? All you really needed was to bring policymakers up to date with the current state of Keynesianism!

Furthermore, if we're going to judge an economic doctrine not by what well-informed people thought, but by the crude caricatures of the doctrine that penetrated the consciousness of ill-informed policymakers, what does that say about supply-side? I was in DC, on the staff of the Council of Economic Advisers, in 1982-3; let me tell you, the supply-siders around really did believe the crudest, most caricatured versions of the doctrine you can imagine. I recall a meeting in which David Stockman tried to explain why we were having a recession, without the benefit of any coherent economic model - and it made the most vulgar Keynesianism sound like Nobel-quality thought.

The key thing is that good Keynesianism, as embodied even in undergrad textbooks of the time, was *perfectly OK*: Dornbusch and Fischer, 1978 edition, offered a description of what disinflation would look like that matches the experience of the 80s reasonably well, and the textbook does not seem all that dated even now. The idea that we needed a new doctrine to get our heads straight is just all wrong.

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Brad DeLong: How Supply-Side Economics Trickled Down...: Brad DeLong follows up on the conversation on supply-side economics, in particular what we knew at the end of the 1970s and in the early to mid 1980s and what constituted Keynesian policy during that time period:

How Supply-Side Economics Trickled Down..., by Brad DeLong: Bruce Bartlett's piece on supply-side economics:

How Supply-Side Economics Trickled Down - New York Times: AS one who was present at the creation of "supply-side economics" back in the 1970s, I think it is long past time that the phrase be put to rest. It did its job, creating a new consensus among economists on how to look at the national economy. But today it has become a frequently misleading and meaningless buzzword that gets in the way of good economic policy...

sparked an interesting and useful debate at Mark Thoma's Economist's View (which I previously noted).

After thinking about it, I want to weigh in again--on the side of Bruce Bartlett as opposed to Paul Krugman. It's not that Paul says anything wrong about what he and his MIT colleagues thought at the end of the 1970s, but IMHO he underestimates the intellectual gulf between Cambridge and Washington.

There are two issues here--stabilization policy and growth policy.

On stabilization policy, Bartlett says that the Keynesians around 1980 believed that full employment should be produced via fiscal policy--spending increases and tax cuts, preferably spending increases, to boost aggregate demand--and that inflation should be controlled via incomes policy--jawboning unions to restrain wages and businesses to keep a lid on prices, tax penalties for price increases, excess-profits and other taxes to provide incentives to keep wages and prices close to previous nominal anchors, and the threat and perhaps the reality of wage and price controls. Monetary policy, Bartlett says they said, was next to useless in controlling aggregate demand. And the principal effect of fiscal policy was not its impact on the supply side--on incentives to work and invest--but its demand-side impact on the volume of spending.

Krugman protests that what he and his Keynesian colleagues at MIT taught around 1980 was very different from Bartlett's parody of modern Keynesianism. MIT's Robert Solow had argued for JFK in the early 1960s that a good fiscal policy needed to pay at least as much attention to the supply side as the demand side. And certainly those teaching macroeconomics at MIT at the end of the 1970s--Stan Fischer, Rudi Dorbusch, and company--placed enormous stress on the power of monetary policy to affect aggregate demand, shape expectations, and control inflation. All this is true. And yet, and yet...

Matthew Shapiro of the University of Michigan perhaps puts it best. He went to Yale as an undergraduate in the late 1970s and to MIT as a graduate student in the early 1980s. He says (roughly, this is my memory and not verbatim):

At Yale in the 1970s, I was taught that the Chicago School was bad and wrong because they believed that monetary policy had powerful effects on production and unemployment. Then I get to MIT in the early 1980s and was taught that the Chicago School was bad adn wrong because they believed that monetary policy did not have powerful effects on production and unemployment.

The second Chicago School was made up of the rational expectations revolutionaries of the late 1970s. The first Chicago School was that of Milton Friedman's monetarists who thought that controlling inflation was simple: don't use open market operations to expand the money supply. They were opposed by Old Keynesians who thought that monetary restraint was ineffective, by those who thought that monetary restraint was too effective (i.e., would cause too much unemployment), and by those (like Arthur Burns) who thought monetary restraint was impossible (i.e., that the Congress would never allow the Federal Reserve to stop inflation by generating a recession the size of 1982). My take on this story is found in J. Bradford DeLong (1997), "America's Peacetime Inflation"; and J. Bradford DeLong (2000), "The Triumph? of Monetarism". The first Chicago School by and large won the day, and Paul Krugman takes their substantial victory as natural and inevitable, and it did indeed seem that way from MIT in 1980, but not from the trenches of the Joint Economic Committee where Bruce Bartlett wallowed in the political trench-warfare mud in the late 1970s. So it seems to me that Bruce is more right than Paul.

I'm less sure that Bruce Bartlett was on the side of the angels on growth policy. I was taught that one sought to have cyclical deficits in recessions, but a budget in balance or surplus on average over the business cycle, so that the mix of policy tended toward a tight fiscal-easy money configuration that would produce high investment and rapid wage, output, and productivity growth, and one paid attention to high marginal tax rates and the deadweight losses they caused. Nothing that Bruce would disagree with there. And certainly I am on Bruce's side against those who focused exclusively on how high marginal tax rates were a good thing because they improved the distribution of income, and those who focused exclusively on fiscal policy as a manager of aggregate demand.

But in practice... it seemed to me that Bruce's political masters like Jack Kemp were excessively eager to throw the "budget in balance or surplus on average over the business cycle," and that the eager embrace of deficits and their crowding-out of investment did more harm than the focus on reducing marginal tax rates did good. We can argue about that, however.

A good deal of the problem is that there were so many factions. On the left side, there was the Solow tight fiscal-easy money tradition; the Musgrave progressive-redistributive-tax-system tradition; the vulgar Keynesians who never met a deficit or a price control they didn't like; the New Keynesian faction to which Krugman belongs, and others. On the right side, there were Bruce Bartlett and company; the neoconservatives who wanted rhetoric but didn't care about getting economic policy right; those who were loyal to Reagan whatever Reagan would decide but had no clue about policy; David Stockman who hoped that cutting taxes now would produce a wave of revulsion against deficits that would enable him to cut spending later; the Buchanan-Niskanen "we are betrayed" faction that protested against the embrace of deficit spending by the Republicans; and the "starve the beast" faction. "What the supply-siders thought" depends very much on who is included in the charmed circle, and when. And the same applies to "What the Keynesians thought."

I entered graduate school in 1980 so let me try to contribute by giving a brief outline of what I was taught. I was not at a top 20 school - far from it - and maybe the gulf between Pullman, Washington and Washington, D.C. wasn't as large as the gulf between Cambridge and Washington. But perhaps that doesn't matter when it comes to policy in Washington versus what was known in the academic community, and as Brad notes, there was quite a lot of variety across graduate programs in terms of what was emphasized.

Though it started with a pretty traditional IS-LM framework with some AD-AS thrown in, by the end of my time in graduate school in the mid 1980s the New Classical model was the dominant paradigm. Much of the game was to try and punch holes in the result that comes out of the New Classical framework that only unanticipated money can affect real variables like output and employment.

This assault came on both theoretical and empirical fronts. Mishkin, for example, had published a paper in the early 1980s that challenged work by Barro and others from the later 1970s supporting the New Classical model and its implication that only surprise money matters. On the theoretical front, the old Keynesian model which had been criticized for, among other things, lacking microeconomic foundations and lacking rational expectations, was being reconstructed into the New Keynesian model. This model would eventually overcome theoretical objections that plagued the older Keynesian model, and it would also do a better job of explaining the magnitude and persistence of business cycles and other features of the macroeconomic data. We learned some about Real Business Cycle models - but for the most part that work went on elsewhere and would surface later as a more general opposing model to New Keynesian framework. But we were certainly made aware of it, e.g. arguments about reverse causality to explain statistical money income correlations. I'd say the same about growth theory - we did the Solow-Swan basics, but very little beyond that. Stabilization policy was the main issue we worried about at the time.

Did money matter? I thought it did, that's what my dissertation was all about, theoretical and empirical reasons to doubt the New Classical model result that expected money does not affect output, but the issue simply was not settled at that time. We now accept, for the most part, that the Fed can affect real interest rates and also affect the real economy, but at the time there was a very strong split within the profession on this issue. It wasn't until later that a more general belief that anticipated monetary policy was a potentially useful stabilization tool surfaced in the profession. It's sometimes surprising to me today how complete the conversion on that issue has been, though it's certainly not 100%.

So, no, it wasn't generally agreed that money mattered, i.e. that money was a useful policy tool for stabilizing the real economy. But the Keynesian economics I learned at the time, which was in the implicit and explicit labor contracting framework for the most part due to who taught the courses, did say that money mattered. In fact, since the point was to challenge the New Classical result that money did not matter, the focus was mostly on monetary policy. As for fiscal policy, the Keynesian model we talked about - beyond the simple IS-LM version we learned at first - paid very little attention to fiscal policy, though certainly challenges such as Barro's "Are Bonds Net Wealth" were part of the conversation. Thus, within the beginnings of the New Keynesian framework that I learned, how changes in monetary policy affected the real economy was the primary focus.

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What Did You Know, and When Did You Know It?: In the comments to my discussion of his NY Times article "How Supply-Side Economics Trickled Down," Bruce Bartlett says:

Interesting discussion. However, I think Mark misses the historical context of my analysis. In the 1970s, we were unaware of real business cycle theory or New Keynesian theory. We were confronting Old Keynesian theory. What Mark has basically done is take a current theoretical debate and superimposed it on the 1970s. That's fine if one's goal is to understand how the economy really worked in the 1970s or what the actual effects of policies taken at that time were. But as a matter of history, it is misleading. We didn't know any of this stuff because it didn't exist then. We were dealing with a far different situation in terms of what people knew about the economy (or thought they knew) and that's one reason why I believe that terms like "supply-side economics" have outlived their usefulness. The context in which the term had meaning no longer exists and therefore it has become a barrier to communication rather than a facilitator.

And, in another comment, he adds:

People need to keep in mind that this was not some purely theoretical debate taking place at some academic conference or in the pages of obscure journals. The people I was working with were members of Congress and their staffs and we were battling specific policies by putting forward specific policies of our own. Many people on both sides were unaware of the theoretical underpinnings because they were unstated, implicit. Part of the supply-side strategy was to make those assumptions explicit. I mention some of them in my article.

Paul Krugman then says:

Bruce Bartlett says this:

Among the beliefs held by the Keynesians of that era were these: budget deficits stimulate economic growth; the means by which the government raises revenue is essentially irrelevant economically; government spending and tax cuts affect the economy in exactly the same way through their impact on aggregate spending; personal savings is bad for economic growth; monetary policy is impotent; and inflation is caused by low unemployment, among other things.

Wow. You see, I was a grad student at MIT - the great Keynesian stronghold - in the 1970s, and this bears no resemblance to what was being taught.

In fact, I still have my copy of Dornbusch-Fischer, Macroeconomics, the 1978 edition - and it doesn't make any of those assertions. I'm particularly amazed by the "monetary policy is impotent" bit: no mainstream Keynesian in America believed that any time after, say, 1955. Dornbusch-Fischer is mainly *about* monetary policy, and how important it is.

Let me suggest that good economic doctrines don't have to be sold by misrepresenting what other doctrines say.

Which then set off a discussion on what we knew and believed in the 1960s and 1970s. Bruce Bartlett responds to Paul Krugman with:

If Paul Krugman is right, then where did all the policy mistakes of the 1970s come from? Why did the Fed act as if the money supply had no linkage to inflation until Volcker changed gears in 1979? Why did the Congressional Budget Office routinely report that a tax rebate, a permanent tax rate reduction, and an increase in government purchases would have exactly the same macroeconomic effect because their only impact was on aggregate spending? I have some of those old reports in my library and can dig them out if necessary.

Of course, there were those in academia who knew better. Maybe Paul was one of them. But they weren't in charge of the Fed or the CBO. Also, I think a lot of economists who lived through the the 1970s and know better today have simply forgotten how screwy some of the economic policies of that time were and how many reputable economists supported them. Go back and read Leonard Silk's columns in the New York Times to see what mainstream economics was all about in those days. Don't go back now and cherry pick the isolated case where someone had it right. We had to do what we were doing in real time without the luxury of long and careful study of all the alternatives. It was a crisis atmosphere and we did the best we could with what we had to work with.

Paul Krugman responds:

A late entry - I'm on the road.

Anyway, Bruce Bartlett's contention that the inflation of the 70s happened because people didn't think money mattered is just bizarre. There was a way too expansionary monetary policy in 1972, not because people didn't think it mattered, but because they did: it's widely believed that Arthur Burns pumped up the economy in an attempt to help Nixon win the election. Nixon's people worried about the effects of monetary policy all the time!

We might also want to mention two horrific oil shocks.

Again, what Bruce is describing is a caricature of a vulgar ultra-Keynesian, circa 1947. People like that never dominated Keynesian thought in the United States, and were pretty much nonexistent by the time supply-side economics came into existence. And no, it's not a matter of policy entrepreneurs versus academics: look at the people who were actually advising Gerald Ford or Jimmy Carter on economic policy, and they were nothing like the caricature Bruce describes.

It's sad, really: to make supply-side economics look respectable, it's apparently necessary to pretend that everyone else was an idiot.

Bruce Bartlett then says:

I think Paul's memory is just wrong. Has he forgotten how intense the arguments were about monetarism? A lot of people thought Milton Friedman's monetary ideas were crazy. And while it's true that Arthur Burns did a horrible job as Fed chairman, he inherited a situation in which inflation was already a serious problem. Jimmy Carter clearly had no clue about it and appointed G. William Miller as Fed chairman who gave us double digit inflation. I remember him testifying before the JEC that inflation was caused by failure of the anchovy harvest. I'm not making this up. They are used in fertilizer, which raised the cost of farming, which raised the cost of food and so on. Maybe up at MIT, people had it all figured out. But down in Washington, where I was, a lot of important people were seriously clueless.

Lawrence H. White of the Division of Labour recalls his classes at Harvard:

I was a freshman taking Economics 10 at Harvard in 1973 (my section was taught by Chip Case). Our textbook was Lipsey and Steiner. Unlike Paul Krugman, I find Bruce Bartlett's characterization of the Keynesian beliefs of time quite accurate.

"Budget deficits stimulate economic growth"? We were at least taught that they raise the level of income, via the balanced-budget multiplier.

"The means by which the government raises revenue is essentially irrelevant economically"? Well, in the macro half of the course, yes.

"Government spending and tax cuts affect the economy in exactly the same way through their impact on aggregate spending"? Yes.

"Personal savings is bad for economic growth"? Well, bad for the level of income, due to the paradox of thrift.

"Monetary policy is impotent; and inflation is caused by low unemployment, among other things." Yep. We were never taught MV=PY. We actually did hear that the bad anchovy harvest was a cause of inflation. A teaching assistant named Roger Brinner wrote an article about the causes inflation for the Harvard Independent (undergrad newspaper) in which he made not one mention of the word "money", much less any reference to growth in the supply of money.

What do I remember about economics in the 1970s? I was an undergraduate in the late 1970s and we learned the traditional IS-LM model, but not the "vulgar Keynesian" version - monetary policy could be used to lower interest rates and stimulate investment and output. We spent quite a bit of time studying the "transmission mechanism" for both monetary and fiscal policy and the special cases within the Keynesian framework when either of the two might fail to be an effective policy instrument. Here's more on "vulgar Keynesians":

Vulgar Keynesians, by Paul Krugman: Economics, like all intellectual enterprises, is subject to the law of diminishing disciples. A great innovator is entitled to some poetic license. If his ideas are at first somewhat rough, if he exaggerates the discontinuity between his vision and what came before, no matter: Polish and perspective can come in due course. But inevitably there are those who follow the letter of the innovator's ideas but misunderstand their spirit, who are more dogmatic in their radicalism than the orthodox were in their orthodoxy. And as ideas spread, they become increasingly simplistic--until what eventually becomes part of the public consciousness, part of what "everyone knows," is no more than a crude caricature of the original.

Such has been the fate of Keynesian economics. John Maynard Keynes himself was a magnificently subtle and innovative thinker. Yet one of his unfortunate if unintentional legacies was a style of thought--call it vulgar Keynesianism--that confuses and befogs economic debate to this day. ...

Consider, for example, the "paradox of thrift." Suppose that for some reason the savings rate--the fraction of income not spent--goes up. According to the early Keynesian models, this will actually lead to a decline in total savings and investment. Why? Because higher desired savings will lead to an economic slump, which will reduce income and also reduce investment demand; since in the end savings and investment are always equal, the total volume of savings must actually fall! ...

Such paradoxes are still fun to contemplate; they still appear in some freshman textbooks. Nonetheless, few economists take them seriously these days. ... What has made it into the public consciousness--including, alas, that of many policy intellectuals who imagine themselves well informed--is a sort of caricature Keynesianism, the hallmark of which is an uncritical acceptance of the idea that reduced consumer spending is always a bad thing...

To justify the claim that savings are actually bad for growth (as opposed to the quite different, more reasonable position that they are not as crucial as some would claim), you must convincingly argue that the Fed is impotent--that it cannot, by lowering interest rates, ensure that an increase in desired savings gets translated into higher investment. ...

No, to make sense of the claim that savings are bad you must argue either that interest rates have no effect on spending (try telling that to the National Association of Homebuilders) or that potential savings are so high compared with investment opportunities that the Fed cannot bring the two in line even at a near-zero interest rate. The latter was a reasonable position during the 1930s... But the bank that holds a mortgage on my house sends me a little notice each month assuring me that the interest rate in America is still quite positive, thank you.

Anyway, this is a moot point, because the people who insist that savings are bad do not think that the Fed is impotent. On the contrary, they are generally the same people who insist that the disappointing performance of the U.S. economy over the past generation is all the Fed's fault... [Slate 1997]

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Bruce Bartlett: How Supply-Side Economics Trickled Down: Bruce Bartlett says we're all supply-siders now, but as explained in some detail below, I don't fully agree:

How Supply-Side Economics Trickled Down, by Bruce Bartlett, Commentary, NY Times: As one who was present at the creation of “supply-side economics” back in the 1970s, I think it is long past time that the phrase be put to rest. It did its job, creating a new consensus among economists on how to look at the national economy. But today it has become a frequently misleading and meaningless buzzword that gets in the way of good economic policy.

Today, supply-side economics has become associated with an obsession for cutting taxes under any and all circumstances. No longer do its advocates in Congress and elsewhere confine themselves to cutting marginal tax rates — the tax on each additional dollar earned — as the original supply-siders did. Rather, they support even the most gimmicky, economically dubious tax cuts with the same intensity.

The original supply-siders suggested that some tax cuts, under very special circumstances, might actually raise federal revenues. For example, cutting the capital gains tax rate might induce an unlocking effect that would cause more gains to be realized, thus causing more taxes to be paid on such gains even at a lower rate.

But today it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue. Last year, President Bush said, “You cut taxes and the tax revenues increase.” Senator John McCain told National Review magazine last month that “tax cuts, starting with Kennedy, as we all know, increase revenues.” Last week, Steve Forbes endorsed Rudolph Giuliani for the White House, saying, “He’s seen the results of supply-side economics firsthand — higher revenues from lower taxes.”

This is a simplification of what supply-side economics was all about, and it threatens to undermine the enormous gains that have been made in economic theory and policy over the last 30 years. Perhaps the best way of preventing that from happening is to kill the phrase “supply-side economics” and give it a decent burial.

It’s important to remember that at the time supply-side economics came into being, Keynesian economics dominated macroeconomic thinking and economic policy in Washington. Among the beliefs held by the Keynesians of that era were these: budget deficits stimulate economic growth; the means by which the government raises revenue is essentially irrelevant economically; government spending and tax cuts affect the economy in exactly the same way through their impact on aggregate spending; personal savings is bad for economic growth; monetary policy is impotent; and inflation is caused by low unemployment, among other things.

These beliefs led to many bad economic policies. In particular, they lay at the root of stagflation, that awful combination of high inflation and slow growth that bedeviled policy makers in the 1970s. Based on insights derived from the Nobel-winning economists Robert Mundell, Milton Friedman, James Buchanan and Friedrich Hayek, the supply-siders developed a new program based on tight money to stop inflation and cuts in marginal tax rates to stimulate growth.

As the staff economist for Representative Jack Kemp, a Republican of New York, I helped devise the tax plan he co-sponsored with Senator William Roth, a Delaware Republican. Kemp-Roth was intended to bring down the top statutory federal income tax rate to 50 percent from 70 percent and the bottom rate to 10 percent from 14 percent. We modeled this proposal on the Kennedy-Johnson tax cut of 1964, which lowered the top rate to 70 percent from 91 percent and the bottom rate to 14 percent from 20 percent.

We believed that our tax plan would stimulate the economy to such a degree that the federal government would not lose $1 of revenue for every $1 of tax cut. Studies of the 1964 tax cut showed that about a third of it was recouped, and we expected similar results. Thus, contrary to common belief, neither Jack Kemp nor William Roth nor Ronald Reagan ever said that there would be no revenue loss associated with an across-the-board cut in tax rates. We just thought it wouldn’t lose as much revenue as predicted by the standard revenue forecasting models, which were based on Keynesian principles.

Furthermore, our belief that we might get back a third of the revenue loss was always a long-run proposition. Even the most rabid supply-sider knew we would lose $1 of revenue for $1 of tax cut in the short term, because it took time for incentives to work and for people to change their behavior. ...

Moreover, we were adamant that only permanent cuts in marginal tax rates would stimulate the economy. We thought that temporary tax cuts, tax rebates, tax credits and such were economically worthless, and we strongly opposed them.

Today, hardly any economist believes what the Keynesians believed in the 1970s and most accept the basic ideas of supply-side economics — that incentives matter, that high tax rates are bad for growth, and that inflation is fundamentally a monetary phenomenon. Consequently, there is no longer any meaningful difference between supply-side economics and mainstream economics.

There is no question in my mind that we never could have overcome the stagflation of the 1970s as quickly or with as little pain as we did without the supply-side idea. But supply-side economics has done its job, just as Keynesian economics did in the 1930s. Those who campaign as its champions are fighting a fight long won — and it is time for supply-side rhetoric to go, with its essential truths embodied in mainstream economics and its perversions discarded for good.

As noted above, I don't fully agree, so let me cast this debate in a different framework where it's easier for me to highlight where we differ.

Let's start with the following fairly standard picture of the evolution of GDP. The red line shows actual output cycling over time, and the blue line shows that natural rate of output which also varies over time:

As depicted, the natural rate is subject to both permanent and temporary supply shocks causing growth to be uneven, but generally upward, and actual output is driven away from the natural rate by demand shocks. That is, the variation in the blue line is from supply-shocks, and the deviation of the red line from the blue line is from demand shocks.

In general, there are two types of policies to consider. The first is the use of monetary and fiscal policy to stabilize the economy. The goal here is to use changes in the money supply, government spending, and taxes to manage aggregate demand and minimize the deviations of actual output from the natural rate of output. This is shown by the dotted red line in the following diagram which is closer, on average to the natural rate than the no-policy outcome shown as the solid red line:

The second type of policy is growth policy. This is what many people mean when they use the term supply-side policy. The goal here is to increase the growth rate of output. This is shown by the upward rotation of the trajectory for the natural rate in the following diagram:

The natural rate of output is determined by the growth of technology, the growth of the capital stock, and the growth of the labor force so policies to increase the growth rate of output are directed at these factors. Examples of supply-side policies are (not all have proven to be equally effective, or effective at all in some cases, and this is far from exhaustive) tax breaks for research and development (to increase technology), tax breaks for IRAs (to increase saving, investment, and the capital stock), tax cuts on capital gains and dividend  (to make capital markets more efficient and increase the capital stock), spending on education (to make labor more productive), reductions in marginal tax rates (so people will increase work effort), accelerated depreciation (to make investment cheaper and increase he capital stock), and reductions in estate taxes (so people will work harder to leave more for their heirs).

Note also that it is the upward rotation in the supply-curve that generates the increase in taxes from supply side policies that you often hear about. The question, of course, is how much additional growth comes from a cut in taxes and here I agree to some extent with Bruce Bartlett. It depends upon the type of tax cuts that are enacted, some are more productive than others and hence some types of tax cuts generate more tax revenue than others. Whether the tax cut is permanent or temporary is also important.

We'd disagree over the magnitude however. While some types of tax cuts can affect growth, the effect is nowhere near large enough to generate a 33% tax revenue recovery rate, not even close, and, in any case, all the low-hanging fruit has already been plucked, something that is often overlooked.

That is not the end of our disagreement. Bartlett does not distinguish between various classes of models, between the short-run and long-run, or between stabilization and growth policy all of which are important distinctions so let me touch upon these issues.

There are two predominant views of the source of fluctuations in output, Real Business Cycle models and New Keynesian models.

Real Business Cycle (RBC) theorists believe that most if not all fluctuations in the economy are due to supply side shocks, aggregate demand shocks such as changes in the money supply, changes in taxes, and changes in government spending affect nominal variables such as prices but have little to do with changes in output over time (however,  government intervention does causes inefficiencies in these models so that less intervention is generally preferred to more). Thus, for RBC advocates, the red and blue lines lie nearly on top on one another because nearly all of the movement in output is due to supply shocks.

Obviously, then, in these models demand management - monetary and fiscal policy - can stabilize prices (and hence increase efficiency), but demand management has little effect on output.

Thus, since short-run demand management is ineffective in these models (and often counterproductive), all that's left is long-run growth policy and that's why people such as Bruce Bartlett, who have an RBC model in mind when thinking about policy, tend to focus on long-run, supply-side, growth enhancing policies.

Let me turn next to Keynesians. My focus is on the New Keynesian (NK) school, but I should note that I don't agree with all of the characteristics Bartlett associates with Keynesians of the 1960s and 1970s, and I certainly don't agree with the claim made in the next paragraph that after the policy failures of the 1970s "the supply-siders developed a new program based on tight money to stop inflation and cuts in marginal tax rates to stimulate growth." A standard expectations augmented Phillips curve story does a much better job of explaining these events, and the interest rate targeting rules used from the early 1980s onward are not based upon RBC models. Most RBC models don't even include money as it plays not role in either the short-run or long-run.

New Keynesians (NK) do not deny that shocks to aggregate supply can affect GDP nor that supply shocks can be large and important. However, New Keynesians also believe that aggregate demand shocks are important, i.e. that the difference between the blue and red lines is large.

New Keynesians attempt to stabilize actual output around the natural rate as shown above. Why does NK policy tend to focus on demand shocks rather than supply shocks? The answer is that although it would be ideal if we could use supply-side polices to smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot do this. As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect output in the long-run, but they are all but useless in dealing with short-run fluctuations in the economy (thus, RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. As we learned in the 1970s, demand side tools are not very effective instruments for offsetting supply-side shocks - trying to use demand side policy to offset supply shocks helped to generate the stagflation we saw at the time. We've learned since then, but practically we are still somewhat powerless to offset supply side shocks in the short-run - all we can do is manage demand to match changes in supply. That is, if a hurricane wipes out supply, we can use policy to reduce demand to match, but we can't do much to increase supply back to its initial level in the short-run.

What we can do much more effectively, if you believe in NK models, is stabilize demand shocks through demand management policy. These policies are relatively simple conceptually, the trick is to manage demand so that upward and downward demand shocks are offset by appropriate changes in policy, but that is easier said than done. Still, we do appear to be able to reduce variation over time through both monetary policy in particular, and also through fiscal policy (e.g. through automatic stabilizers).

The claim made by Bruce Bartlett that "there is no longer any meaningful difference between supply-side economics and mainstream economics" is not something I can agree with. There are big differences between the RBC and NK schools and big differences in the implications of the two schools for policy in the short-run. RBC advocates do not believe in short-run stabilization policy, their focus is solely on maximizing long-run output growth. NK theorists do not deny that robust economic growth is important, but they also believe that government can play a helpful role is smoothing short-run economic fluctuations.

Why do Republicans tend to endorse the RBC framework? I believe in many cases that belief in the RBC model arises from an honest view that the evidence is most supportive of this class of models. But in other cases I believe it is an ideological marriage. The RBC model has two features that make it attractive.

First, because it says short-run stabilization policy is ineffective, and that government intervention through either spending or taxes generates economic distortions, the RBC framework supports an approach where the role of government in the economy is minimized.

Second, because the RBC framework allows for tax cuts to produce higher growth by reducing inefficiencies, and because it is then possible to argue that tax revenues might increase, it gives two reasons for supporting tax cuts - higher growth and less than a full loss of tax revenue, i.e. a dollar tax cut does not cost a dollar (or, for serious ideologues, the tax-cuts even pay for themselves).

The NK model, on the other hand, supports active government intervention which is at odds with this ideology. In addition, because the focus in NK models is on stabilization of output around the natural rate, not on growth of the natural rate, tax-cuts do not have the dynamic long-run effects as in RBC models (though these can be added) and hence there is not as much ideological support for tax cuts in the NK framework.

This is much too long already, but a few more things. We don't we know which type of shock is most important? If demand shocks play a substantial role, we should pay attention to the NK policy prescriptions, but if aggregate supply shocks are the primary force behind business cycles, we should abandon short-run stabilization and focus solely on long-run growth. We don't we just look at the empirical evidence and figure this out?

The problem, essentially, is that we only have one time-series, GDP, and we want two things from it, supply shocks and demand shocks. Since we only have one piece of information and want two things from it, we must make an assumption of some sort. Under some assumptions, supply shocks appear predominant, but under others, demand shocks are the most important factor in business cycles. Because we have no way of knowing for sure which assumption is best, and because the econometric evidence changes as the assumptions change, we are left with uncertainty as to which type of shock matters most and hence which model we ought to prefer.

There is much more to say about all of this, I haven't even mentioned New Classical models, but that will have to do for now. Summarizing, contrary to what is implied in Bruce Bartlett's commentary, there are two distinct schools in economics, the RBC school and the NK school, and they have very different policy implications. Not everyone will agree with this, and that is the point I suppose, but I would argue that the mainstream view today is the NK model, though the RBC school has strong advocates and has made important contributions to our thinking (the long-run incentives Bruce Bartlett mentions are a good example).

So, here's where we agree. Both NK and RBC advocates see the long-run similarly. Both schools agree that demand side polices have little effect on long-run growth. Both agree that incentives matter, and that we should, of course, strive to enhance efficiency and long-run growth whenever possible. There is a difference in the two schools as to the strength of those incentives, but if that is all that is meant by supply-side polices, then fine, no problem, we're in agreement.

But there is a big disagreement over the short-run. RBC adherents take a hands-off, free market approach. Their model tells them that government interference causes inefficiencies, and that there is nothing to be gained in return in terms of enhanced stability. NK adherents believe government should take an active role in stabilizing the economy and that is something that, contrary to what is implied above, has not changed since the 1960s and 1970s. The model used by the NK school is very different from the models we used then - and our approach to policy is similarly different - but the basic idea that government intervention can help to stabilize output and employment in the short-run is unaltered.

Update: See comments by Bruce Bartlett and Paul Krugman.

Update: More at Angry Bear, Political Animal, Ezra Klein, Angry Bear again, Division of Labour, and Tim Worstall. Update: Brad DeLong too. . Update: One more from Angry Bear. Update: Lawrance Lux comments. Update: Angry Bear with more. Update: Talk Left also.

Update (4/11): Follow-up here.

Comments

[robertdfeinman]

There are two possibilities.
1. Policy makers were (are) really uninformed about economic theory, or
2. They are not.

Using David Stockman is the perfect example. He spouted the most ridiculous nonsense when he was in government, but was honest enough to admit that he knew this was bunk after he left. I'm guessing that this is more true than we think. For every Rick Santorum there really are people who know what is going on, but chose to distort the information.

The super rich go to great lengths to fund "think tanks" which promote policies backed up by dubious theories which favor their interests. The purpose of these institutions isn't scholarship, it's propaganda disguised as scholarship. That's why most of their white papers are not peer reviewed and most of their funding is hidden from view.

Instead of arguing over history, perhaps it is just simpler to look at the outcome. Since Reagan (or Nixon, if you prefer) there have been two major trends. First, the rich have gotten much richer and second, the country has lost its economic engine. We now borrow and buy abroad instead of lend and sell abroad.

Forget the theories and look at the results. We don't make stuff, our infrastructure is falling apart, our workforce is undereducated for the tasks ahead and we face climate and resource challenges of an unprecedented nature.

What are we going to do about it? Or are we just going to become a tourist destination like the imaginary Merry Olde England that the UK has become.

[Movie Guy]

I'm an outcome and results thinker. That's my bottom line. And my energies are focused on those goals.

I don't have any claim or offer any significant support to Supply-Side Economics or Supply-Side Political Economics as the primary spokesman and promoter Jude Winniski called it. But I doubt that many reading these few threads are getting the sense in the differences from what was originally termed Supply-Side Economics and what is being considered with the realm of Supply-Side today.

If the distinction isn't made and the original writings and limited materials are ignored or brushed aside, I would like to hear the new apply-it-all-to Supply-Side Economics definition spelled out much better than what Paul Krugman has shared.

Where do we go next? What will be the principal economic theories adopted by national leaders going forward after 2008? What will that be called and what will it specifically entail beyond known existing theories?

Will the next policy approach, whatever it is and none know right now, work? Will it reverse income inequality, significantly reduce trade deficits and fiscal deficits, and allow for greater transfer payments including universal health care coverage however packaged or optioned? What will matter most in the next Administration on the economic front?

These are valid questions that any economic advisor to a Presidential candidate should be addressing.

What is the opinion of well established or young yet openminded economists who are willing to address the needs of the future today?

What is your opinion, Paul Krugman?

We can't blame Supply-Side Economics forever. So, what's next?

What policy based upon what economic theories package will work in this global environmental that is built upon more open borders and continued displacement of significant value-added production of goods and services (other than geographic dependent) for a nation that the U.S. Census Bureau projects to double and yet satisfy the future demands of global warming adjustments and reduction of energy consumption?

I expect that this collective situation will require serious thinking by well reasoned and flexible individuals skilled in many disciplines, not so unlike the needs of the 1970s when the U.S. faced another group of crisis situations.

[Movie Guy]

If we're going to keep looking back, I suggest that it's time that the following facts were plugged into the reality of the discussions and compare the theories to the on the ground realities. I don't know what the best answers were, but I know that pressing situations were at hand during the 1970s and shortly thereafter.

Here are but just two considerations by year:

Year - Inflation / Unemployment

Nixon Administration
1969 - 5.46 / 3.49
1970 - 5.84 / 4.98
1971 - 4.30 / 5.95
1972 - 3.27 / 5.60
1973 - 6.16 / 4.86
1974 - 11.03 / 5.64

Ford Administration
1974 - 11.03 / 5.64
1975 - 9.20 / 8.48
1976 - 5.75 / 7.70

Carter Administration
1977 - 6.50 / 7.05
1978 - 7.62 / 6.07
1979 - 11.22 / 5.85
1980 - 13.58 / 7.18

Reagan Administration
1981 - 10.35 / 7.62
1982 - 6.16 / 9.71
1983 - 3.22 / 9.60
1984 - 4.30 / 7.51
1985 - 3.55 / 7.19
1986 - 1.91 / 7.00
1987 - 3.66 / 6.18
1988 - 4.08 / 5.49

G.H.W. Bush Administration
1989 - 4.83 / 5.26
1990 - 5.39 / 5.62
1991 - 4.25 / 6.85
1992 - 3.03 / 7.49

Clinton Administration
1993 - 2.96 / 6.91
1994 - 2.61/ 6.10
1995 - 2.81 / 5.59
1996 - 2.93 / 5.41
1997 - 2.34 / 4.94
1998 - 1.55 / 4.50
1999 - 2.19 / 4.22
2000 - 3.38 / 3.97

G. W. Bush Administration
2001 - 2.83 / 4.76
2002 - 1.59 / 5.78
2003 - 2.27 / 5.99
2004 - 2.68 / 5.53
2005 - 3.39 / 5.08
2006 - 3.24 / 4.63

Sources:

The US Misery Index

Graphic & Numbers
The US Unemployment Rate - 1969 to 2006

Graphic & Numbers
The US Inflation Rate - 1969 to 2006

[paine]

i actually thought for once i'd written a useful post
my point was simple

the effectiveness in some cases the sole effectiveness
of fiscal policy was the real casualty of the meme wars of the late 70's early 80's
not that the k team failed to remember the string push that monetary policy becomes in a true investment bust
like 1930-1933
a bust that really only ended with
the investment boom
set off by the arsenal of democracy
and the relentless uncle sam directed and funded
storming of the limits
of
increasing output

but hey ...

lets argue about other stuff
like monetary policy vis a vis anti wage push

that's what the black hats want
no more then for us to forget fiscal policy

except when deficits might crowd out
brad's next green field rubber tire plant
or some oaf thinks job multipliers
come out of the barrel of a deficit increase

erp erp erp

" fine tuning alert
all interceptors please report
to their monetary stations
immediately

[gordon]

The Wikipedia article on supply-side economics refers to Say's Law in the second line: "The central concept of supply-side economics is Say's Law". If this is right, the rise of supply-side economics during and after the Reagan presidency, when memories of the Depression were dying out among the voters, seems strongly to support J.K.Galbraith's statement (in "Money; Whence It Came, Where It Went"):"Say's Law stands as the most distinguished example of the stability of economic ideas, including when they are wrong".

[Bruce Wilder]

I just wanted to acknowledge that I have followed this series with great interest. The exchange in the post were revealing, and raised some questions I may ponder. Thanks to Prof. Thoma and the various participants.

I did not have any comment to make, but, somehow, I thought it might be appropriate to make known my gratitude to our host.

[anne]

Having just finished another complete reading, I could not be more grateful to this policy history series. Though I am most sympathetic to Brad DeLong in the argument, the argument has been excellent. I am more impressed with Bruce Bartlett's nuanced development than Paul Krugman or even Mark Thoma, but I understand Krugman's academic complaint and Thoma's remembrance helps considerably.

[save_the-rustbelt]

What opened the door to supply side economics?

The day Reagan was inaugurated the prime rate was about 19.5% and inflation about 12.5% (could be off a tad).

These circumstances were doing really severe damage to the American people. Really nasty, I learned business bankruptcy accounting from 1979 - 1982.

That damage ended the Carter administration and opened the door to something new.

The Keynesians opened the door for the supply siders.

[paine]

"These circumstances were doing really severe damage to the American people"

it was the cure that killed rusty

credit withdrawal from commercial outfits with grid locked payables/ recievables

the system needed ....carter to co ordinated a huge short burst payroll tax cut
with a somewhat more surgical credit operation
then the hunish PV pulled off
plus a dollar prat fall against the yen/mark
or else type approach
to kick up exports reducxe imports
drop the global price of oil faster

(recall the yen/oil price
based attack had parallels
to todays rmb/oil price based attack

notice i don't fault reagan
the ronald macdonald of the GOP
NOPE a FISCALLY PRUDENT DEMOCRAT
was the real culprit
and he was thrown out of office just as he deserved to be

(i say that while loving the guy personally )

ronnie's
utterly voodooo
supply side hooey
with its massive big boy tax cut
basis in reality

led to lovely economy reviving
rolling deficits

ie his magic chatter
allowed normal demand management
to kick start a belated recovery

[reason]

Doesn't anybody realise that the rest of the world went through the same thing, regardless of the colour of the government. In Australia, it is fairly clear to me that most of the influences were international. In order to combat inflation, tariffs were cut, import quotas done away with and the exchange rate floated. That made the excessive budget deficit unsustainable. I was there when it all happened. Yes we all saw JK Galbraith and Milton Friedman on TV, but their influence was fairly secondary.

Americans can be so parochial!

[paine]

reason

" In order to combat inflation
tariffs were cut, import quotas done away with and the exchange rate floated "

okay so now the system is more open
and thus more competitive
and less supply constrained
great wage push full price increase pass thru
gets croaked ..
or slowed anyway

but how does that make an ".... excessive budget deficit unsustainable" ????

if so then
down under
seems
to translate as
topsy turvey macro

i see no reason
reason
why open trade and a floating exchange rate
restricts the the size of the fiscal deficit ????

[Prantha Trivedi]

I was a bankruptcy lawyer during the late 1980s. Reagan's "Tax Reform Act" created a boom in the bankruptcy bar (it actually changed the character of bankruptcy practice by attracting a new breed of "ungentlemanly BK lawyers." I stopped practicing BK. But I digress . . .)

I recall a president of a corporation in bankruptcy in 1988, who explained how "Supply-Side Economics" was his undoing. He had a HUGE supply (of materials), but there was no demand. Not enough "trickled down" to the average American. This is how he understood the economic theory of the time!

Movie Guy: It would be great if you could gather the statistics relating to the numbers of BUSINESS (corporate) bankruptcies, and individual bankruptcies to your "Inflation/Unemployment" chart!

[real person from the real world]

Robertfeinman: "Forget the theories and look at the results. We don't make stuff, our infrastructure is falling apart, our workforce is undereducated for the tasks ahead and we face climate and resource challenges of an unprecedented nature."

You are "SPOT ON."

Education, Inc. has done nothing to help US Citizens to get educated in subject domains we need. The Conservatives have everyone in an uproar about "illegal" (read latino/mexican) aliens who take the lowest level jobs in the economy, while Overpaid Corporate Business, Inc. is unwilling to create entry level jobs in IT and they emport people from abroad who got their entry level elsewehre already. Health Care Inc., is busy gouging those who are unfortunate enough to get sick without coverage, while sucking in the dollars from the well heeled and denying coverage to anyone that might actually cost them a cent in the future. Marketers and advertisers charge whatever the market will bear. Credit card companies gouge consumers but got the politians to roll back bankruptcy protections. Monopolies are rising. Gas is rising, but Public transportation has never gotten the support it should, while the auto makers churn out gas guzzlers and Bush and his oil buddies push wheelbarrows of money to the bank. We fight an unpopular war, where our soldiers are not given the protective armor that could save their lives. Everything is outsourced to some capetbagger and Everything in this country is a F_ _ _ _ _ g Business. Those who benefit like things just fine, the rest of us are going down the toilet.

[Lafayette]

MT: This is shown by the dotted red line in the following diagram which is closer, on average to the natural rate than the no-policy outcome shown as the solid red line .... The second type of policy is growth policy.

A Unified Economic Theory of Behaviour

You hope, Mark. Please, do show, by means of historical reference over a suitable time-frame, in a conclusive manner that the above should indeed be true.

I propose that no such record exists and that, even from the point of view of history, that such a cyclic behaviour, bending to the influence of any given economic policy by the government can have the effects cited in that graph.

I will agree that molding economic debate around "poles" (Friedman on the Right, Keynes on the Left) is bereft of any rationality whatsoever.

Economic behaviour changes, because economies change. Let's look a just a few factors that we failed to understand fully:
* Who was talking about the necessity of P2E (Perennial Productivity Enhancement) when Supply-Side came on the scene more than thirty years ago?
* Who was considering the effects of long-term low rent of money on the American economy, as has been recently the case five years ago?
* Who predicted that the doubling of the global supply of labor, almost all of it a tenth cheaper than developed countries, would spark such a shift of capital to these countries emerging from the darkness of centralized communism?
* Who was predicting a "what if?" scenario for when the demise of communism would liberate this labor?

Polemical economic debate seizes upon one idea as a seminal explanation of a phenomenon ... and then another and then yet another -- the result being a cycle of debates that enlarges the picture, but never quite defines it completely.

Because the subject matter (the economy) is developing/morphing/evolving in ways that are both unforeseen and -- worse yet -- quite likely unforeseeable.

We must learn to look at the future not with myopic spectacles from the past but an entirely new set of lenses. These lenses contain many different focal lengths: One traditional, one sociological, one that captures underlying global trade currents, one psychological and yet another political. Worse yet, not all these factors cited are mathematically treatable variables. That is, it will be difficult to reduce them to one simple econometric model.

There will never likely be a "unified economic theory" that pulls all foci together. Because the reduction of all these factors individually to a singular explanation would be absurd; having lost their individual meaning/credibility in the reduction. Methinks, or rather, I suppose; because if I could foresee such a theory, I'd be writing a paper about it.

And, I can't. Or, maybe I just don't know how? Let's hope so.

NB: The last factor listed above (political) has been predominantly affecting the Global Economic System during the past two decades. We did not foresee the full impact of the fall of communism, GATT widening trade so expansively and China rising to the challenge with a combination of both cheap labor and talent. Now we do ... all to well -- but it's too late. We have been passive spectators to the spectacle. And, as a punishment for our laxity (whilst we focused on capital accumulation), the West will be playing economic catch-up for another ten years, whilst the sun continues to rise in the East. (That is, only ten years if we are lucky.)

[Lafayette]

reason: Americans can be so parochial!

It made other mistakes

Every nation is "parochial" in some way. Ours is a vast world of one-way streets.

America has no particular patent on vested interests, just a rather unique notion of them. That is, full of hubris ... as if the "good ole days" would last forever because America was dynamic and decent and brave and straightforward and honest ... and all that was God's will.

It is, really, more naive than most -- or so the world thinks. And, Americans think, in return, "Well, we didn't make the same mistakes as you, did we?" True enough, America didn't make the same mistakes. It made other mistakes.

Besides, America distinguishes itself patently by its accent upon "success", particularly as demonstrated conspicuously by accumulated wealth. Mind you, that is not altogether very different from China today, itself looking for some cultural icons after nearly 70 years in the proletarian darkness.

China too is quite possibly making the same mistake.

[reason]

paine...
Inflation reduces the real value of the debt principle. When the inflation goes everybody says OMG how will we ever pay the debt.

[Lafayette]

reason: When the inflation goes everybody says OMG how will we ever pay the debt.

Goes where? You haven't explained what goes where ...

The Chinese have been creditors holding Treasury notes that they bought at dollar parities much lower than today. Should we buy back that debt, it would not only pay with cheaper dollars (and the Chinese would find themselves paying dearer for Euros, let's say); but the mere fact of retiring T-notes would reduce their price. It's (of sorts) a double whammy.

Some of those dollar parities (to the Euro, for instance) where damn expensive. If they had bought T-notes in the nineties (with the dollars from US imports), then exchanging them for Euros represents one helluva depreciation in value. (The dollar was once at 85 cents to the Euro. It is now at 143 cents to the dollar. That's a 68% devaluation.)

In fact, the Chinese probably diversified early on into European currencies, particularly after the advent of the Euro.

Should they sell T-notes willy-nilly, the dollar will likely plummet. They hold One Trillion dollars in reserves.

Imagine this: They sign a deal with OPEC to sell dollars (expressed in T-notes) on the open exchange if OPEC charges a Euro denominated oil price. The dollar sinks, the cost of oil skyrockets in winter (up 43% as of today, if the cost were denominated in Euros) ... and Americans freeze their you-know-whats. (Er, cars. Whatever. ;^)

[Glenn Nickerson]

Why was the net capital rule (Rule 15c3-1) changed by the SEC in 2004 for just five companies? (see article excerpt & links below)

-------------------

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.

You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.

Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.

Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.

As Mr. Pickard points out that "The proof is in the pudding — three of the five broker-dealers have blown up."

-------------------

http://bigpicture.typepad.com/comments/2008/09/regulatory-exem.html

http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/