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Wednesday, April 11, 2007

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.

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.

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]

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.

    Posted by on Wednesday, April 11, 2007 at 02:00 PM in Economics, Macroeconomics | Permalink  TrackBack (0)  Comments (19)



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