TCS Daily


Whose Supply-Side Are You On?

By Arnold Kling - March 10, 2003 12:00 AM

For die-hard hippies, it is always August 1969 and "I'm goin' on down to Yasgur's farm." If you suggest that we are no longer Woodstock Nation, they get very bitter.

Supply-side economists present a similar profile. They challenged the establishment, and for one shining moment in 1981, they had their Woodstock, as President Ronald Reagan managed to push through a major tax cut. However, like the hippies, supply-side economists have either been co-opted or marginalized over the years. These days, they can be found carping about the appointment by President Bush of Harvard's N. Gregory Mankiw as Chairman of the Council of Economic Advisers.

As the New York Times reported, the supply-siders that Mankiw once derided in a textbook as "charlatans and cranks" were certainly cranky. Think-tankers Martin Anderson and Stephen Moore are quoted as hostile to Mankiw.

The Wall Street Journal's Susan Lee (subscription required) is not re-fighting the battles of the 1980's. Her objection to Mankiw is current. She complains that "his best-selling textbook argues that deficits or government debt pushes up interest rates." (Susan Lee may not know this, but Glenn Hubbard, Mankiw's predecessor as CEA Chairman, also has a textbook, which says the same thing.)

What Was Supply-Side Economics? Anyone? Anyone?

If you missed Ben Stein's lecture in "Ferris Bueller's Day Off," you can find some explanations that are almost as good on the Web. James D. Gwartney writes, "Supply-side economics stresses the impact of tax rates on the incentives for people to produce and to use resources efficiently." Raymond Keating writes, "in the supply-side view, the size of government generally takes precedence over concerns about, for example, the size of a nation's budget deficit."

In the 1980's a bona fide supply-sider believed that cutting tax rates would lead to higher tax revenues. As Brad DeLong describes it, supply-side economics was used to deny the inconsistency between the goal of tax reduction and the goal of deficit reduction. While DeLong, no friend of supply-side economics, acknowledges that its proponents take a different view of history, my memory coincides with DeLong's.

Supply-Side Economics and Deficits

In 2003, supply-side economists are no longer suggesting that cutting tax rates will increase government revenue. On the contrary, Milton Friedman and Gary Becker are saying that cutting tax rates is a way to put downward pressure on government spending, presumably by reducing revenues.

The new "litmus test" for supply-siders appears to be the belief that government deficits do not increase interest rates. Susan Lee is accusing Mankiw of heresy in that regard.

In making the case that larger government deficits do not lead to higher interest rates, Lee gives several somewhat mutually inconsistent arguments:

  1. Ricardian equivalence

    According to this hypothesis, as individuals we "see through" the Budget and realize that deficits now will lead to higher taxes later. Therefore, we save now in order to pay those taxes. I do not know anyone who makes their savings decisions by looking up the government Budget data. So you have to argue that somehow people are factoring in the government Budget implicitly without being aware of it. Although as an economist I believe that people can solve complex optimization problems intuitively if they have enough practice, there is no way for people to "practice" making long-term saving decisions--you only go around once in life.

    Lee says that "most" economists "work with some form" of Ricardian equivalence. That sentence is true, if by "work with some form" you mean "are aware of but dismiss."


  2. International Capital Flows

    Lee's next line of defense is that "any left-over pressure will be absorbed by global capital markets." It is true that if private net saving does not increase to match an increase in the government Budget deficit, then the gap must be met by foreign capital inflows. However, the mechanism by which this occurs is that higher interest rates attract foreign capital. Thus, although foreign capital attenuates the effect of the Budget deficit on interest rates, it does not eliminate it. Moreover, when deficits get large enough, foreign capital can turn around and go the other way. See Argentina.


  3. Small Change

    Lee's other argument is that deficits are small, so that the increase in outstanding debt is negligible. She writes, "Global credit markets are enormous -- around $40 trillion -- and the U.S. government deficit represents a small share. In fact, next year's deficit of some $300 billion is truly a drop in the bucket."

    This is true. A one-time Budget deficit of $300 billion is not large in comparison with GDP, total credit flows, or other appropriate metrics. Of greater concern is the outlook in the years ahead. The Committee for Economic Development forecasts that over the next ten years the cumulative deficits will be $2 trillion. That is not small change. As Everett Dirksen might have put it, a trillion here a trillion there and pretty soon you're talking about real money.

The supply-siders are bitter with Greg Mankiw and the rest of us. However, we are the ones who ought to be bitter, because supply-siders are weakening the conservative position.

The real debate in this country should be over the appropriate size of government, particularly the future of Medicare. Those are topics on which conservatives hold at least some (I would say a lot) of the intellectual high ground. Instead, the supply-siders would make their stand on the proposition that tax cuts can be sustained without spending cuts, using theories that rest on intellectual quicksand.
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