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Tuesday, October 13, 2009

"Supply-Side Economics, R.I.P."?

Bruce Bartlett says supply-side economics should "should declare victory and then go out of existence.":

Supply-Side Economics, R.I.P., by Today is the official publication date of my latest book, The New American Economy. In this post I'd like to explain a little bit about why I wrote it and how I arrived at my present state of mind, which seems to be confusing to many of my friends.
The book grew out of an op-ed I had in the New York Times back in 2007. In it I argued that supply-side economics (SSE) should declare victory and then go out of existence. Everything that was true about it had by then been fully incorporated into mainstream economic thinking and all that was left was a caricature. Continuing to maintain a separate identity for SSE only created unnecessary conflict with mainstream economists, I argued.
As a member of Jack Kemp's congressional staff back in the late 1970s, I had a front-row seat to the creation of SSE. ... I was the person on Kemp's staff whose job it was to actually draft and promote the Kemp-Roth tax bill, which was adopted by Ronald Reagan during the 1980 campaign and enacted into law in August 1981. It brought the top marginal income tax rate down from 70 percent to 50 percent, among other things. ...
I continue to believe that what the supply-siders did was good for the economy, good for the country and good for the advancement of economic science. The best economists in the country were pretty clueless about our economic problems during the Carter years. It was widely asserted that the money supply had no meaningful effect on inflation, that marginal tax rates had no incentive effects, and that it would take decades or another Great Depression to break the back of inflation.
As all economists now know, these ideas were wrong. All economists today accept the importance of the money supply--perhaps too much; during the recent crisis many asserted that fiscal stimulus was unnecessary because an increase in the money supply was the only thing necessary to restore growth. (How this would have been accomplished when interest rates were close to zero was never explained.) All economists now accept the importance of marginal tax rates to economic decisionmaking...
During the George W. Bush years, however, I think SSE became distorted into something that is, frankly, nuts--the ideas that there is no economic problem that cannot be cured with more and bigger tax cuts, that all tax cuts are equally beneficial, and that all tax cuts raise revenue.
These incorrect ideas led to the enactment of many tax cuts that had no meaningful effect on economic performance. Many were just give-aways to favored Republican constituencies, little different, substantively, from government spending. What, after all, is the difference between a direct spending program and a refundable tax credit? Nothing, really, except that Republicans oppose the first because it represents Big Government while they support the latter because it is a "tax cut." I think these sorts of semantic differences cloud economic decisionmaking rather than contributing to it. As a consequence, we now have a tax code riddled with ... schemes of dubious merit...
The supply-siders are to a large extent responsible for this mess, myself included. We opened Pandora's Box when we got the Republican Party to abandon the balanced budget as its signature economic policy and adopt tax cuts as its raison d'être. In particular, the idea that tax cuts will "starve the beast" and automatically shrink the size of government is extremely pernicious.
Indeed, by destroying the balanced budget constraint, starve-the-beast theory actually opened the flood gates of spending. ...[I]f, as Republicans now maintain, taxes must never be increased at any time for any reason then there is never any political cost to raising spending and cutting taxes at the same time, as the Bush 43 administration and a Republican Congress did year after year.
My book is an effort to close Pandora's Box and explain to people why I believe that SSE should go out of business--or declare victory and go home, if that makes the idea easier to accept. To the extent that it has any valid insights left to inform policymaking they should be used to design a tax system capable of raising considerably more revenue at the least possible economic cost. Going forward, I believe that financing an aging society and a permanent welfare state is the biggest economic problem we face. ...
As I thought about the cycle that SSE had gone through from a response to the failure of Keynesian economics in the 1970s to triumph in the 1980s to caricature in the 2000s, it occurred to me that SSE and Keynesian economics had a lot in common. Each had been developed in response to serious economic problems that the existing orthodoxy was incapable of dealing with, both struggled for acceptance but were ultimately implemented to great success, both were then misapplied in inappropriate circumstances, thus leading to them becoming discredited.
So basically the book is about the rise and fall of Keynesian economics followed by the rise and fall of SSE. Although the Keynesian part of the book was originally intended to flesh out my model of the rise and fall of economic theories, it turned out to have very valuable lessons for today. Indeed, the circle appears to have come around to where Keynesian theories are now the best ones we have for dealing with today's economic crisis. ...
The General Theory, I think, was really just Keynes' way of making some relatively simple ideas look scientific in order to make them more acceptable to policymakers. The first idea is that deflation was the central economic problem. Second is that it was impractical to cut money wages to reduce unemployment and restore equilibrium. And third is that monetary policy was impotent because the economy was in a liquidity trap. ...
Economist Irving Fisher added an additional component ... by showing that the zero-bound problem is a very serious impediment to monetary policy... Fisher also explained that deflation magnified the real value of debt, which became a crushing burden on both households and businesses that reduced spending and growth.
What both Keynes and Fisher said was that when the economy is in a deflationary depression the collapse of private spending had to be compensated for by public spending, because that was the only way to get money circulating and make monetary policy effective. While monetary policy would drive the recovery it needed fiscal policy in order to work.
When the economic crisis hit in the fall of last year, I was very grateful for having studied the Great Depression and absorbed the work of great thinkers like Keynes and Fisher because, as Yogi Berra might have said, it was déjà vu all over again.
It seemed obvious to me right from the beginning that there was a close parallel between the causes of the Great Depression and the current crisis. The principal difference is that the former was caused by a collapse of the money supply resulting from the closure of many banks and the disappearance of their deposits, while the latter was caused by a fall in velocity resulting from a sharp decline in consumer spending following bursting of the housing bubble. (Because GDP equals the money supply times velocity, a decline in velocity has exactly the same effect as a decline in the money supply--nominal GDP must shrink, which causes both prices and output to fall.) ...
[M]y ... analysis led me to support a large fiscal stimulus. Without public spending on goods and services I didn't see any way for monetary policy to be effective... I was disappointed that so little of the February stimulus package went to the purchase of goods and services, which drives spending, and so much into economically ineffective transfers, which don't. But I understood that time was of the essence and that taking the time to design a better package would have required even more effort to overcome the economy's inertia, not to mention the political obstacles.
In researching my book I saw many points early in the Great Depression when a little bit of the right monetary and fiscal stimulus might have turned things around and made it just a run-of-the-mill recession. But as effective action was delayed year after year, more and more effort was needed to get the economy off a dead stop. It was only when all constraints on spending and money growth were cast aside during World War II that the Great Depression really ended.
I believe that relatively modest action early last year could have forestalled the current crisis or at least mitigated it substantially. I think the tax rebate was wrongheaded and a complete waste of money, and that the money would have been better spent cleaning up the housing mess. ...[B]ut the Bush administration's obsession with tax cuts as the sole cure for every economic problem--even when they involved nothing more than mailing out government checks--blinded it to alternative policies that might have nipped the housing problem in the bud and prevented the banking system from imploding.
By September, it was obvious to me that substantial government funds would be necessary to bail-out the financial system and prevent a systemic collapse that would have cost vastly more and imposed vastly greater economic hardship. I thought this argument was pretty straightforward and been well accepted by economists ever since the time of Walter Bagehot in the late 18th century. ...
I remain incredulous that serious economists not only opposed TARP, but also argued that tax cuts were the only fiscal stimulus the government should have engaged in--if it did anything at all. ... I really don't understand how tax cuts would have done the slightest bit of good when millions of people had no income because they were unemployed, when businesses had no profits to tax, and investors had huge capital losses that will offset all of their gains for years to come. Given such economic conditions--resulting from a lack of demand, not supply--it's nonsensical to think that tax cuts would have helped. Indeed, one can make a case that the tax cuts included in the stimulus bill were its least effective element.
Many of my friends believe I have abandoned supply side economics and become a Keynesian. ... But as I try to explain in my book, my views haven't changed at all; it's circumstances that have changed. I believe that my friends are still stuck in the 1970s when tax rates were considerably higher and excessive demand (i.e., inflation) was our biggest economic problem. Today, tax rates are much lower and a lack of demand (i.e., deflation) is the central problem. I really don't understand why conservatives insist on a one-size-fits-all economic policy consisting of more and bigger tax cuts no matter what the economic circumstances are; it's simply become dogma totally disconnected from reality.
Nor do I understand the conservative antipathy for Keynes, who was in fact deeply conservative. He developed his theories primarily for the purpose of saving capitalism from some form of socialism. Same goes for Franklin D. Roosevelt, whose biggest economic mistake, I believe, was not that he ran big budget deficits, as all conservatives believe, but that he didn't run deficits nearly large enough until the war forced his hand. ... People can judge for themselves if I prove my case. ...

I'm between classes so I don't have time to add much, but the op-ed linked above that Bartlett says motivated him to write the book sparked a long, detailed, and intense discussion here when it was first published among Bruce Bartlett, Paul Krugman, Brad DeLong, Jamie Galbraith, and Lawrence White among others (I weigh in too, but I would not write it the same way today). See:

    Posted by on Tuesday, October 13, 2009 at 12:45 PM in Economics, Fiscal Policy, Macroeconomics, Taxes | Permalink  Comments (34)


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