The Bush administration should heed the Old Testament warning that “no man can serve two masters” in explaining its economic policies. Specifically it must clarify whether its policies are Keynesian or supply-side in design. They can’t be both at the same time.
First, a review: John Maynard Keynes argued governments could counteract harmful short-term economic swings that were manifest in either inflation or unemployment. The tools for such economic management were fiscal policy — taxing and spending — and monetary policy — the money supply and interest rates.
The Federal Reserve has a monopoly on monetary policy, so when presidents or congresses seek to follow Keynesian policies, they can only work with taxes and spending.
When the problem is inflation, Keynes prescribed tax increases and government spending cuts. If, instead, a recession with unemployment was the problem, he suggested cutting taxes and increasing spending.
Keynes never argued that large increases in national debt are beneficial. Keynesian policies would involve running budget deficits during recessions, but offsetting budget surpluses when the economy was strong.
Keynesian policies were termed “demand management” from the underlying assumption that either inadequate or excessive overall demand for goods and services were at fault when the business cycle caused problems.
Inflation results from excessive consumer, business and government buying of goods and services. Increased taxes, the remedy, leave households and firms with less to spend. Cuts in government outlays produce the same result for the public sector. These measures will decrease overall demand and reduce price increases.
Unemployment results from inadequate consumer, business and government purchasing. Cut taxes so households and companies have more to spend. At the same time, increase direct government purchases of goods and services. Such steps increase demand spurring greater output and employment.
Not all economists swallowed Keynesian theory hook, line and sinker. The number of skeptics grew as governments following Keynesian policies encountered rising levels of both inflation and unemployment in the 1970s.
Two new critiques of Keynes emerged. One, rational expectations, argued on highly theoretical grounds that Keynesian demand-management actions were futile or even counterproductive.
Another, supply-side economics, had very little theory but asserted that Keynes erred in emphasizing short-term manipulation of the “demand side” of the economy. Such manipulation was counterproductive in the long run. Far better to concentrate on the “supply side” of the economy by reforming inefficient government regulation and by reducing high marginal tax rates for wealthy households.
These measures would not counteract short-term business cycle fluctuations. Instead they would set the economy on a long-run path of higher income growth. Aiming tax cuts at the wealthy was an integral part of the package since the wealthy are far more likely to invest dollars from tax cuts rather than spend them. Greater investment was the key to growth.
Supply-siders made it clear you could not be a Keynesian and a supply-sider at the same time. That would be like Columbus navigating while simultaneously assuming that the world was both round and flat.
Keynesians advocated temporary tax cuts to spur consumption and ameliorate short-term unemployment. Supply-siders advocated long-term tax cuts for high-income people to increase investment and spur long-term growth.
Neither group advocated large increases in national debt. Keynesian tax increases in booms would produce surpluses to offset deficits run during busts. Cuts in spending would partially offset supply-side tax cuts. Eventually, economic growth would increase the tax base and thus revenues.
Supply-side economics had much more support in the popular press than it ever did among professional economists. However, Lawrence Lindsey, Bush’s initial economics adviser, was both a respected economist and an advocate of supply-side approaches. The first Bush tax cut, planned in 2001 when we still had naive predictions that the entire national debt would be paid off in a decade, was presented as a supply-side measure.
Lindsey was dropped after making the preposterous suggestion that the Iraq war might cost a couple hundred billion dollars. And the administration has used Keynesian arguments for subsequent tax cuts arguing that reduced taxes would increase consumer spending, not investment.
In his campaign, Bush argues that his tax cuts stimulate more consumer spending and greater savings and investment. All the while, he ignores the effects of government borrowing on money available for investment in plants equipment and training.
Keynes and the supply-siders cannot both be true. The Bush economic team must choose whom it will serve. If Keynes is right, Bush should call for tax increases as the economy strengthens, not still more cuts. If the supply-siders are right, they need to curb government spending, not increase it at near record rates.
Some economists derive much amusement as Bush economic advisers like Greg Mankiw, in their efforts to defend an incoherent policy, repeatedly contradict what they wrote before joining the administration.
But for the rest of us it is no laughing matter.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.