A Very Good Conversation on Supply-Side Economics

Mark Thoma quotes large chunks of Bruce Bartlett's views on supply-side economics:

Economist's View: Bruce Bartlett: How Supply-Side Economics Trickled Down: Bruce Bartlett says we're all supply-siders now... I don't fully agree:

How Supply-Side Economics Trickled Down, by Bruce Bartlett: 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.... President Bush.... Senator John McCain.... Steve Forbes... Rudolph Giuliani....

This... 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.... 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... personal savings is bad for economic growth; monetary policy is impotent.... These beliefs... 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.... 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.... Furthermore, our belief that we might get back a third of the revenue loss was always a long-run proposition.... 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.... [S]upply-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.

And Mark Thoma comments:

As noted above, I don't fully agree.... [T]here are two types of policies to consider. The first is the use of monetary and fiscal policy to stabilize the economy.... The second type of policy is growth policy.... The goal here is to increase the growth rate of output.... The question... is how much additional growth comes from a cut in taxes.... 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... and, in any case, all the low-hanging fruit has already been plucked....

Let me turn next to Keynesians. My focus is on the New Keynesian (NK) school.... 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.... 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....

So, here's where we agree. Both NK and RBC advocates [today] 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.... 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....

And Bruce Bartlett replies:

Bruce Bartlett: 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...

Others comment:

Blissex says: I think that Bruce Bartlett here is being a bit of a revisionist, but his conclusions are sounder than that. In the 50s-60s the new-Keynesian betrayal of Keynes was that output problems were essentially always an issue of insufficient demand, a position of extraordinary faith in the markets. The idea was that markets would provide plenty if only insufficient demand traps were avoided. In hindsight that was ridiculous, and the idea that excessive levels of distorting taxation were stifling the operations of the markets, not just insufficient demand, was sound, and that it is now widely accepted is good, as the markets cannot simply adjust to any conditions except insufficient demand. I think however that Bruce Bartlett's memories are gravely wrong in two ways: He compares the ''realistic'' supply siders of the 1970s with the delirious ones of today, but in the heat of political discussion the claims of many influential 1970s supply siders were as extreme as today's, including Reagan's. The great inflation of the 1970s was not cured by supply-side economics, but simply by a change of political objectives. Inflation was as always solely a political phenomenon, the consequence of seignorage. In the 1960s policy was butter-and-guns, and to increase social stability in difficult times with a policy of easy, easy money, favouring debtors and holders of real assets with very low interest rates. In the 1970s politics reversed, as the Vietnam war was wound down, and Volcker implemented a ferocious policy of high interest rates, favouring creditors and holders of financial assets. Very, very little to do with supply side economics...

Bruce Bartlett says: 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...

real person from the real world says: I think one of the points Barlett makes is that an idea was hijacked. A simplistic slogan that was based on an economic concept that you may or may not agree about, was used over and over again, to justify the implementation of some very self serving policies by past Republican administrations, and those who had the bucks used it as their banner. What's been done is done, now is the time to fix the mess that has been created, except the wrong people (corporate America, and the supper wealthy) now have all the power to stymie any pragmatic reform that rocks their nice little boats...

Paul Krugman says: 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...

Bruce Bartlett says: 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....

Blissex says: 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? They were not mistakes, they were deliberate policies designed to pursue political important goals. Keeping the voters happy during difficult times was deemed more important than price stability.... 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. Well, a large part of that was excessive faith in the ability of markets and entrepreneurs to adapt to any conditions. Instead the one great legacy of ''supply side'' was to point out that government policy matters as to creating a suitable climate for business and growth, as the markets and entrepreneurs cannot be given for granted, they can't do their job under all conditions...

Bruce Bartlett: Inflation was indeed the central problem. But policymakers were repeatedly told that to bring it down to tolerable levels would require an economic contraction as long and as deep as the Great Depression. It was hard to argue that the benefits of ending inflation were greater than the negative effects of another Great Depression. So policymakers just kept monetary policy on automatic pilot until the spectre of hyperinflation emerged. At that point, every serious person knew that something had to be done. Where I credit supply-side economics is in making the transition from a high inflation environment to a low inflation environment as quick and painless as possible. Of course, the 1981-82 recession was painful, but it was less painful than the 1974-75 recession, which did little to even moderate inflation, and a lot less painful than the Great Depression. If we hadn't cut tax rates in 1981 and taken the other supply-side measures Reagan took, the transition would have been vastly longer and more painful, in my opinion...

knzn: By most measures, the 1981-82 recession was more painful than the 1974-75 recession, and in fact the latter did moderate inflation, as you can see if you look at the inflation series in the 1975-77 period. The problem was that the Fed pushed the recovery too hard. What Volcker was willing to do, specifically, was to keep the 1981-82 recession going for as long as necessary to get inflation down to an even lower level and then to be very cautious about pushing the recovery. I strongly disagree with the opinion that cutting tax rates prevented the transition from being more painful. Volcker’s credibility helped, but the tax cuts meant that interest rates had to be higher for longer and that traded goods industries suffered long-term damage due to a strong dollar.... Also, I don’t know who was saying that brining inflation down “would require an economic contraction as long and as deep as the Great Depression.” It’s true that conventional Keynesian estimates of the sacrifice ratio were higher than what it turned out to be, but not so dramatically higher. I think you would have a very hard time finding any actual economist of the time who came up with a quantitative estimate of the required contraction that came anywhere near the severity of the Great Depression.

Blissex says: If we hadn't cut tax rates in 1981 and taken the other supply-side measures Reagan took, the transition would have been vastly longer and more painful, in my opinion. As to that I quite agree -- in part because it is sensible, standard Keynes-style fiscal policy ;-), in part because the level of taxation had reached ridiculous levels.

Note however that as remarked long ago, "ridiculous" above does not necessarily mean "damaging", as top tax rates were very high in the fifties too, a golden era. The case against excessively high taxes is mostly moral (confiscation), rather than economic, while the case against excessively low ones is economic (a business and growth friendly infrastructure is expensive) as well as moral.

Howard, for working men in the fifties, it was a much better economy then than it is today. Now I'm not talking about civil rights and the like. Well, that was in part because of politics. Working white men were the pillars of USA conservativism (and they still are, inasmuch they are asset and gun owners), and the inflation of the late 60s and the 70s was in part designed to buy them off; the buying off was in part meant to conserve their support for the war, in part to keep them happy even if blacks and women were given civil rights, in part to detach their interests from those of students and other ''subversive'' elements (the latter especially in Europe)...

Bruce Bartlett says: In an article in the American Economic Review (May 1978), Arthur Okun said that to reduce the basic inflation rate by 0.3% would require raising the basic unemployment rate by one percentage point for one year. With inflation well into double digits by 1980, one can see that it would indeed require unemployment on the scale of the Great Depression to bring inflation down to a tolerable level...

Paul Krugman says: 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 an 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 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...