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August 13, 2006
David Warsh, Proprietor


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Supply-side Economics at 25

When I bought some stamps at the post office the other day, around the corner from former House Speaker Thomas P. (Tip) O’Neill Jr.’s old house, I asked for a sheet of Ronald Reagan commemoratives. “I have mixed feelings about Ronald Reagan,” I said to the man who sold me the stamps

After all, the clerk probably owed his job to Tip, who led a long and good-natured rear-guard action in opposition to Reagan’s enthusiasm for generally smaller government, including fewer post offices. And indeed I do have mixed feelings. I like the post office, for example, just as I like the privately-owned UPS store across the square.

But on one count, I no longer harbor any ambivalence at all. Ronald Reagan was the most important US president since Franklin Roosevelt was elected, nearly fifty years before. His policies, like those of Roosevelt, set a mood and direction that would dominate US politics for decades after he left office.

It was 25 years ago this weekend that Reagan signed the Economic Recovery Tax Act, which slashed personal income tax rates and indexed tax brackets for inflation. So hastily written was its reduction of the corporate tax rate that the statute had to be amended the next year, lest budget deficits spin completely out of control.

But in combination with the stringent monetary policy being pursued by Federal Reserve chairman Paul Volcker (a lifelong Democrat appointed by Jimmy Carter in 1979), and a wave of new technological opportunities (made possible by decades of government investment), the stimulus was more than enough to get the economy growing again. The expansion that began in 1982 has continued, despite some thrills and spills, with only a pair of recessions to the present day. A certain amount of credit can be laid to the simplification that began with the 1981 tax act; a certain amount to Reagan’s willingness to tolerate the monetary scourge.

When the editorial page of The Wall Street Journal last week took note of the anniversary, it noted correctly that “the reigning Keynesian policy consensus had no answer” to the predicament that the newly-elected president confronted in 1981. Advisers to Jimmy Carter had considered that inflation was a more or less ineradicable condition of modern capitalism; that stagnation was a serious threat.

When the Journal took credit for what happened next, it may have slightly overstated the case. “…So a new group of economic ideas came to the fore. Actually, they were old, classical economic ideas that were rediscovered via the likes of Milton Friedman and the Chicago School, and such policy activists in Washington as Norman Ture and Jack Kemp, among others. These humble columns under our late editor, Robert Bartley, led the parade.”

There was indeed a time when the Journal’s editorial page absolutely dominated discussion of these topics. Its hegemony has been diminished by the appearance over the years of other voices, but, on some topics, it has remained very powerful. It was unrivalled in its enthusiasm for the invasion of Iraq, for example (though not a little backup was contributed by the front page of The New York Times).

It is, however, hard to exaggerate Milton Friedman’s role in what happened in 1981. It was not just the nine-part Public Television series “Free to Choose” in which he starred with his economist wife the year before. Friedman’s friendship with Ronald Reagan dated back nearly fifteen years, to when Reagan had been governor of California; his political influence to the 1964 Barry Goldwater campaign. And the intellectual influence of his 1962 primer, Capitalism and Freedom, rivalled that of John Maynard Keynes’ 1936 General Theory of Employment, Interest and Money.

As for the “Laffer curve,” the diagram sketched on a napkin by consultant Arthur Laffer by way of arguing that lower tax rates almost inevitably produce big changes in economic behavior; and the authority of Ibn Khaldun, a 14th century Muslim philosopher (who wrote, “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments; at the end of the dynasty, taxation yields a small revenue from large assessments”), it is easy to imagine Reagan saying of his brain trust, as an adviser to Franklin Roosevelt famously said of his, pointing to his suit coat sleeve, “You see these buttons? They don’t do a damn thing, but fashion says I’ve got to have them, so I do.”

What bothers me about supply-side doctrines as they have evolved in political discourse is their tendency to mimic the worst features of Keynesian doctrines of demand management of the 1960s and 1970s — instead of government spending to pump up aggregate demand, tax cuts were required to stimulate aggregate supply. Never mind talking about the rate of economic growth. Supply-siders profess no confidence that a market economy will for the most part run by itself. Instead of sound countercyclical budget policy — a surplus during expansions, a deficit during recessions — they run on the “two Santa Claus theory” of onetime Wall Street Journal editorialist Jude Wanniski, appealing single-mindedly to individual greed.

I much prefer the way that Martin Feldstein put it earlier this year at a Financial Times Deutschland symposium on “What Remains of Keynes’ Work in Today’s Economics?” In fact, increased government spending in emergencies could provide a temporary boost to output, he wrote, “but in the longer run higher levels of government spending crowd out private investment or require higher taxes that weaken growth by reducing incentives to save, invest, innovate and work.” Keynes’ ideas reflected the unusual conditions of the Great Depression, said Feldstein. “Today’s macroeconomic problems require attention to more fundamental forces of individual incentives and institutional rigidities.”

Okay, so politics ain’t beanbag. It ain’t social science either. Perhaps The Wall Street Journal was operating within the limits of reasonable discourse in selling tax cuts as a magic elixir of growth. (I still hold against them their fire-in-a-crowded-theater claims that the Soviet Union had employed biological weapons in Laos during the 1970s — “Yellow Rain” — completely unsupported by evidence after all these years.) It may have been damning with faint praise when Milton Friedman himself wrote in his autobiography that “Robert Bartley’s The Seven Fat Years is a far more accurate depiction of the consequences of Reaganomics than the distorted picture that has been churned out by Reagan’s ideological enemies.” But it certainly it is true, as he continues, that “the firmness, persistence and insight that guided [Reagan's] policy towards the Soviet Union was a major factor in producing the collapse of communism.”

More than 250 years ago, Adam Smith put his laissez-faire economics this way: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes and a tolerable administration of justice; all the rest being brought about by the natural course of things.” We’ve added certain responsibilities to government since then — stable money (under the heading of justice, perhaps), sound countercyclical budget policy, a commitment to education and fundamental research, and sensible management of intellectual property rights. If only that were that were the recipe of supply-side economics, they could count me in.

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