To see economic history come alive, take a closer look at the competing ideas President Bush and Democrats proposed last week to fix the economy.
First, cut through some of the silly rhetoric surrounding the proposals and recognize that they’re based on sharply different theories of how our economy operates.
Let’s start with silliness. Disregard anything that anyone asserts about what will happen in a 10-year period. The exercise is so imprecise as to be meaningless. Instead, look for estimates of effects over the next two or three years. Anything beyond that is pure speculation.
Also disregard all the talk about making temporary tax cuts “permanent.” All taxing and spending bills are ordinary legislation. They can be passed and signed by one Congress and president and then just as easily repealed by the same officials or their successors. There is no way to make any government action “permanent.” Even constitutional amendment can be reversed. Prohibition was.
Having pushed through some verbal smoke, recognize that the competing plans advanced by the Democrats and the administration are based on different theories about what government can do in an economy.
The Democratic plan is unalloyed Keynesianism from the 1960s. The administration’s plan is founded on the supply-side economics that was in vogue in the Kennedy, Johnson and Nixon administrations.
There was a problem, however. Two decades of stepping on economic gas and brake pedals in Western Europe and the United States seemed to increase both inflation and unemployment over the long run. This was the “stagflation” that bedeviled western governments throughout the 1970s.
A younger group of economists, the Rational Expectationists, demonstrated that Keynsian theory had feet of clay. Their demolition of Keynes’ theories, along with the bad experiences in countries that applied them, reduced the popularity of such policies among younger economists.
It is safe to say that while most contemporary scholarly economists recognize that changes in fiscal policy (taxing and spending) or monetary policy (money supply and interest rates) do affect a national economy, few are enthusiastic about using such discretionary policies to manage an economy.
The distinction between influence and control may seem subtle, but it is important. We have a lot of history where fiscal and monetary changes made at the wrong time and to the wrong extent were harmful.
This skepticism among economists has not yet permeated the Democratic Party. They seem sure that if the economy is not performing well, it’s because the government is doing something wrong and they can identify just what needs to be done to make it right.
Last week, the Democrats proposed a $600 tax rebate per household, cutting Social Security payroll taxes and cuts to taxes of small businesses—ideas straight from the Keynes recipe in recession.
Bush’s proposal to cut dividend taxes is based in the anti-Keynes view of supply-side economics. The supply-siders oppose Keynesian fiscal and monetary action to stimulate or retard the “demand-side” of economics. They argued that government should focus instead on reducing whatever government programs inhibited the “supply-side” of the economy.
They identified business regulations and high marginal tax rates as the most important drags on economic growth. High marginal income tax rates, as much as 70 percent for wealthy individuals in the late 1970s, supposedly constituted an important impediment to savings and investment by the class of people with the most potential to invest.
Initially the supply-siders opposed budget deficits as much as other conservative economists. They wanted to reduce high marginal rates on the rich, but not necessarily total tax revenues. But one of them, Arthur Laffer, argued that cutting high marginal rates would stimulate economic output so much that total tax revenues would actually increase. There was such a thing as a free lunch.
Important individuals in the Reagan administration were convinced and the rest is history. We quadrupled our national debt in the 12 years of the Reagan-Bush administrations.
One should not be too hard on the supply-siders. A broad majority of economists accept one of their core ideas: U.S. tax and regulatory policies create disincentives to growth in output and productivity. These policies could be reformed to reduce such disincentives.
That is a long way, however, from the blithe assumption embodied in the Bush proposals that if we just cut taxes on the rich enough, the economy will grow to the benefit of all and that long-term budget deficits will be self-correcting.
This is wishful thinking of the most pernicious kind. Utter moonshine.
There are people of good sense in both parties in Congress. We may come out with a compromise from last week’s proposal that is helpful or, at least, does not harm the economy too much.
But as you listen to the debate over the next few months, realize that neither of the positions is rooted in sound economics.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.