It was about 20 years ago when Alan Reynolds, most recently chief economist of the Hudson Institute, announced with tongue in cheek that he had decided to become a Keynesian. “I will advocate tax cuts in a recession and spending cuts in a boom.” Always a wit, Reynolds described perfectly the giant loophole in the economic framework of the big government Keynesians, who used exactly the same analytical model to prescribe spending increases in a recession and tax increases in a boom. In the management of aggregate demand, either prescription is supposed to work, but economists who advise the Democrats invariably prefer the approach that leads to bigger government. Unhappily, it is this intellectual argument that is dominating political discourse at the moment -- and the financial markets are caught in the resulting cul de sac.
That is, the market is up, the market is down -- in a fairly narrow cycle because of the consensus that the economy is growing at an optimum rate. After more than a half century living in the Keynesian model, which makes it the government’s responsibility to speed things up or slow things down depending upon “where we are in the business cycle,” Republicans in general and George W. Bush in particular find themselves on the defensive when talking tax cuts in a boom. There is no room in the Keynesian model for this prescription and ALL of the economists who advise Governor Bush are conservative Keynesians. How do they defend the $1.3 trillion tax cut they designed for him? Well, it is phased in over a 10-year period, so it will not be inflationary. That leaves Vice President Al Gore with the argument that his smaller targeted tax cuts and spending increases for the poor and the needy will be phased in over the same period. The Republicans complain that Gore underestimates the cost of the targeted spending, which he indignantly denies. Democrats counter that the Bush tax cuts will cost more than $1.3 trillion because by not paying down the national debt by that amount, interest rates will be higher on a larger debt service.
We are sorry to have to bother you with these convolutions, but there is no other way we can think of to have you understand the presidential debate over public finance. Bush is a bright fellow who can run up the learning curve on stuff like this as easily as the next guy, but when he is being taught by Larry Lindsey, Marty Feldstein, John Taylor, and Michael Boskin he is stuck with the happy economic expansion under way. Economic theory is all-important when political leaders who are not trained in economics are engaged in debate. In Saturday’s NYTimes, a cluster of economists and business leaders were asked to assess the Bush tax plan. Their views were almost all predictable, the most enthusiastic a half-hearted Lawrence Kudlow who was alone in citing productivity increases.
The big surprise to me was Ed Yardeni of Morgan Grenfell, for whom I have great respect. Yardeni flat out rejected the idea of any tax cuts and argued all available funds be used to pay down the national debt. The process still would be stimulative, he argued, because interest rates would fall with the decline in debt and this would fuel the equity markets. When I contacted Yardeni to see if there were any tax rates he would reduce to increase the efficiency and productivity of the economy, he responded with a “no.” Pay down the debt! As creative as he has been over the years in assessing the economy and the markets, Yardeni is still a man of demand management and thus caught in the intellectual cul de sac.
In a classical supply model, the federal government would have no role at all in managing aggregate demand. The dollar would be defined as a specific weight of gold and the government could not depart from that commitment by trying to goose the economy with “easy money.” Tax rates would be raised or lowered according to the demands of the budget in peace or war, with no thought at all of pumping up spending simply to create jobs. Tariffs would also be raised for revenue needs only, not for protection from competition, as they were in 1929. It really was not until the late 1940s and early 1950s that academic economists decided Lord Keynes had provided the scientific tools for the central government to at least cut the tops off the booms and the bottoms off the recessions -- which Reynolds addressed with his bon mot. After his election in 1960, John F. Kennedy, who thought like a supply-sider, at first allowed his Keynesian advisors to talk him into a targeted tax credit to get the country moving. Then as now, a targeted tax credit is simply a disguised spending policy, with only incidental supply effects, if any. By 1962, JFK was frustrated by the sleepy economy and was talked into serious income-tax cuts by West Germany’s finance minister, Ludwig Erhard. When enacted after his death, they fueled a stock market boom, the economy flooding with capital that had been inert. The Republicans denounced the tax cuts as being inflationary. The Democratic economists, who had opposed the tax cuts, now took credit for them as proof of Keynesian demand management nostrums.
To be sure, if the Bush tax cuts were enacted, there would be positive supply effects and there would be problems associated with them. At the margin, the capital inflow from abroad would increase, enlarging the current account deficit. The capital/labor ratio thus would increase, a good thing for labor, but disturbing to those at the Federal Reserve who worry about wage inflation. This would be no problem at all if there were serious tax cuts in Canada and Mexico, which would draw capital out of the U.S., a “rising tide,” etc. (Notice Mexico’s President-elect Vicente Fox getting it backwards thus far, suggesting we import more Mexican labor instead of Mexico making its economy more hospitable to capital.)
How do we break out of this intellectual cul de sac? It is not easy, because we have come so far and the IMF/World Bank has held back so much of the rest of the world. It is not likely that Gore is going to lead the way. Bush at least leans in the right direction, but he cannot get the right pictures in his head with the team he has assembled. This is why it would be nice to see Bush even casually mention Steve Forbes as a possible Treasury Secretary. Forbes does think like a supply-sider and understands that if we are going to solve the Social Security/Medicare problem, we will have to increase the capital/labor ratio by at least 50% over the next generation, a process that must begin now. How can it begin, though, if it means an automatic transfer of labor from the developing world to the United States as the only alternative to the Federal Reserve slowing the economy to fight a lower unemployment rate?
There are no problems in political economy without solutions, but the ones we face now are more intricate and involve more variables than we have had in the recent past. When Ronald Reagan proposed tax cuts in the face of a growing budget deficit, he not only had the right supply-side arguments, but also a weak economy with a high unemployment rate. The country was behind him in a way it is not now behind the Bush tax cuts. To get that backing, the Texas Governor needs a better story or Gore will keep him running in defensive circles.