Sound money and income tax cuts — the elements of supply-side economics — have produced economic growth in America, according to Dr. Brian Domitrovic of Sam Houston State University. When our country imposes inflationary loose money policies and high income taxes, economic growth suffers, as in the period from 1973 to 1982. Unfortunately, these are the policies of President Barack Obama and his administration.
Domitrovic lectured on principles in his book Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity last night at Friends University. His lecture was part of the Law, Liberty & the Market lecture series, which is underwritten by the Fred C. and Mary R. Koch Foundation in Wichita.
“Unemployment at nine percent, five grueling quarters of decline in GDP growth, the stock market snapped back from its horrid 50 percent decline, but still needing a good 25 percent to get back to its old high: this has been some economic contraction.” While this may sound like a description of the current recession, it’s not. Instead, Domitrovic was describing the recession of 1974 and 1975. The stagflation period from 1973 to 1982, characterized by both high unemployment and high inflation, was a dark period in American history.
There was also a mortgage and foreclosure crisis during that decade, but it affected the most prudent homeowners the worst. Property taxes in California went up five-fold in a period of ten years. Selling your house resulted in the loss of half your equity because of the capital gains taxes that were in effect then.
While unemployment is high today, inflation is low, with prices even declining slightly last year. Being unemployed while prices are rising at nine percent per year — or 33 percent during one two-year period — is much worse than being unemployed today.
In 1980 the bank prime interest rate reached 22%. (It’s 3.25% today.) It was impossible to save money in the 1970s, as the real tax rates on saving exceeded one hundred percent.
Our economic crisis today is the “junior partner” to the stagflation decade. Our current political leaders should not be comparing the current situation to the Great Depression of the 1930s. Instead, the stagflation period has better lessons to teach us. It took 20 years for American living standards to recover to the level attained before the Great Depression started, Domitrovic told the audience, so we should not implement the same policies in response to the current recession.
Instead, we have a fairly recent crisis — the stagflation period — which was solved “so firmly, so efficiently, so permanently” that the quarter-century following this period is known as the “Great Moderation.” There was economic growth year after year, inflation nearly vanished, unemployment was low, interest rates settled, businesses started, and stocks and bonds boomed.
It was supply-side economics that ended the stagflation and lead to the long period of prosperity, the Great Moderation. Failing to embrace supply-side economics as a response to the economic problems that arose in 2008 was one of our greatest mistakes.
As the current crisis enters its third year, we should not be surprised that recovery is slow to arrive. “Tepid and incomplete recovery was, in fact, the record of the New Deal, which our policymakers have looked to for inspiration,” Domitrovic explained.
Supply-side economics consists of stable money and marginal tax cuts. These are the policies that defeated stagflation and lead to the Great Moderation.
Domitrovic explained that in 1913, two great institutions of macroeconomic management were created, the Federal Reserve system and the income tax. Prior to this time, the United States had no ability to conduct macroeconomic policy, either fiscal or monetary policy.
Since 1913, the economic history of the U.S. has been that of “serial disaster.” From 1913 to 1919, prices increased by 100 percent. Prior to that, there had never a peacetime inflation in the U.S. The top rate of the income tax, which started at a rate of seven percent, had increased to 77 percent by 1917. From 1919 to 1921, the U.S. experienced its worse recession up to that time. Unemployment rose to 18 percent. Prior to this time, unemployment was not a problem.
The fix was President Warren Harding’s Treasury Secretary Andrew Mellon telling the Federal Reserve to keep the dollar stable instead of trying to manipulate the price level, and the income tax rate was cut by two-thirds. As a result, from 1921 to 1929 inflation was low, less than one percent, and that nation experienced the boom known as the Roaring Twenties. Economic progress boomed.
But in 1929, the Federal Reserve started to deflate the currency in an attempt to get prices back to the 1913 level. In 1932 the top income tax rate was raised to 63 percent from 25 percent. “There you have the Great Depression,” Domitrovic said. It was a crisis of macroeconomic management, not a failure of capitalism, as is commonly believed.
Franklin Roosevelt instructed the Federal Reserve to keep the price level steady, which was one good policy he implemented. But he increased income tax rates.
In 1947 income tax rates were cut and the Federal Reserve pursued stable prices after the inflation of World War II.
A pattern emerged: stable prices coupled with income tax cuts lead to recovery. When these policies are not applied, recovery was weak and collapsed. These patterns repeated through the rest of the century.
During the Eisenhower Administration, the top tax rate was 91 percent. Eisenhower refused to cut taxes, and there were three recessions during his presidency.
John F. Kennedy wanted to solve the crisis. His advisors told him to loosen money and raise taxes, even though the top marginal rate was 91 percent. The idea, according to recently-deceased economist and Kennedy adviser Paul Samuelson, was that by increasing the money supply people would spend money, which would cause production to increase and workers to be hired. But increasing the money supply produces inflationary pressures. The solution was very high income tax rates, which sops up the extra money that causes inflation.
But Robert Mundell, only 29 years old at the time, wrote a memo that advised the opposite, advocating stable money and low taxes. Kennedy adopted this policy, and a great boom resulted for seven years.
But Lyndon Johnson asked his Federal Reserve Chairman to increase the money supply, and passed an income tax surcharge to attempt to control the danger of inflation — the “neoclassical synthesis.” Inflation rose. Nixon increased the capital gains tax and established the alternative minimum tax. The result was the double-dip recession of 1969 to 1970, which cost more in economic output than the cost of the entire Viet Nam war.
Still, the Federal Reserve kept increasing the money supply, and the income tax rate was increased. Nixon insisted that printing money would save the economy, and in order to control inflation, Nixon imposed price controls. The result was an investment strike. If businesses could not charge the prices they needed, they would enter other fields of businesses, such as commodities. The prices of commodities rose rapidly, and there was the terrible double-dip recession of 1974 to 1975.
Mundell, along with Robert Bartley of the Wall Street Journal and others, started to encourage government to tighten the money supply and lower taxes. At the same time United States Representative Jack Kemp introduced a bill calling for a large tax cut and stable money. Kemp’s bill passed both houses of Congress with a veto-proof majority. But Jimmy Carter had it killed in committee.
If not for Carter’s action, the Kemp-Roth tax cuts would have become law in November 1978. These tax cuts, had they been passed and been coupled with Carter’s appointment of Paul Volcker — an advocate of stable money — as chairman of the Federal Reserve in August 1979, would have found the policy elements of “Reaganomics” in place at that time. Domitrovic said the economy would have recovered rapidly, and it is likely that Ronald Reagan would not have run for president in 1980.
Instead, the period from 1979 to 1981 was a brutal period of economic history, with high unemployment, high inflation, and tanking markets.
Upon entering office, Reagan was able to implement sound money policy and tax cuts — by then called supply-side economics — and the economy started the boom that lasted for 25 years. During this time there was only one recession, in 1990 and 1991. This is in contrast to the three recessions during Eisenhower’s eight years in office.
Supply-side economics is one of the greatest success stories in economics and government, Domitrovic said. Despite evidence of its success, despite the fact that every objection to it has collapsed, policymakers did not follow its policies in 2008. Objections to supply-side economics that have proven to be unfounded include:
It is inflationary. This is the basis for George H.W. Bush’s characterization of supply-side economics as “voodoo” economics. But inflation since 1982 has been very low.
It would cause crowding-out. This refers to the fact that tax cuts can cause budget deficits, and the government would have to borrow so much money that none would be available for private business investment. But the 1980s, 1990s, and 2000s were a period of historic expansion, with the Dow Jones stock market average increasing by a factor of 15 during this time.
Government debt is a burden to future generations. But the nation experienced great prosperity and economic expansion during the Great Moderation, and interest payments on the debt were not a major burden.
Tax cuts would place the U.S. in a “fiscal hole,” with budget deficits forever. But by the 1990s we were running budget surpluses. Domitrovic said that when Clinton balanced the budget in 2000, the total level of government expenditure was 18.4 percent of gross domestic product. In Reagan’s last year in office (1989) revenues were 18.4 percent of GDP. “In other words, Reagan’s tax policy plus Clinton’s spending policy was exactly sufficient for a perfectly balanced budget.”
Supply-side economics causes inequality. But Domitrovic said that tax cuts mean that wealthy people don’t have to hide their income from taxes, making their income more productive publicly. Inequality has decreased.
Summarizing, Domitrovic told the audience that the lessons of the Great Moderation are that when the institutions of 1913 — Federal Reserve and the income tax — are tamed, the American economy does wonderful things. Stable money and low taxes, combined with the entrepreneurial knack of Americans, produces remarkable economic growth and job opportunities. But when the macroeconomic institutions of 1913 run a muck the economy will suffer. The current policies of the Obama Administration — loose money and rising taxes — are not going to produce prosperity.
“As a result, from 1921 to 1929 inflation was low, less than one percent…”
Not true. In a classical sense inflation refers to the monetary stock and not the general price level.
Rothbard, America’s Great Depression, Chapter 4
“It is generally acknowledged that the great boom of the 1920s began around July, 1921, after a year or more of sharp recession, and ended about July, 1929. Production and business activity began to decline in July, 1929, although the famous stock market crash came in October of that year. … Over the entire period of the boom, we find that the money supply increased by $28.0 billion, a 61.8 percent increase over the eight-year period. This is an average annual increase of 7.7 percent, a very sizable degree of inflation.”
The disastrous institutions of 1913 should not be “tamed”. They should be destroyed.
Fascinating. Another good book to read.
I went ahead and visited his website and listened to a previous lecture he gave, saying basically the same thing. It was very interesting and informative. Plus he’s just a good speaker. Wish I could have been there last night.
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Why don’t we just leave Harry bloody Potter in charge of the economy since we’ve already established that magic is real?
The flaws of this article are mind-blowingly obvious.
First, it refers to a 9 year period in which oil shocks caused by OPEC, not Keynesian policy, hurt the economy, and then presents this as evidence that Keynesian policy doesn’t work.
The same reasoning applies to the reason that it was impossible to save and invest: high inflation coupled with low output due to the lack of available fuel meant that savings rapidly deteriorated in real value and the firms that would otherwise be invested in lacked the raw resources to actually function.
Second, it betrays an utter lack of knowledge regarding US history. “Prior to this time, the United States had no ability to conduct macroeconomic policy, either fiscal or monetary policy.” This obviously disregards the First and Second banks of the US. No ability to conduct fiscal policy? That is utterly ridiculous; that’s like saying the US had no ability to change its budget. The Federal Reserve is in no way associated with Fiscal policy, only monetary. This article, however, conflates the two.
The reason inflation suddenly occurred between 1913 and 1919 was due to the end of the wartime tariffs, rationing and bond issuance that the US government was previously carrying out.
Worse, this article goes on to correlate a rise in the income tax and deflation. Anyone with a basic knowledge of logic would realize that such a correlation does not implicate causation. But this analysis fails there.
“But in 1929, the Federal Reserve started to deflate the currency in an attempt to get prices back to the 1913 level. In 1932 the top income tax rate was raised to 63 percent from 25 percent. There you have the Great Depression,’ Domitrovic said”
Never mind the Stock Market Crash that occurred, despite the deflationary policies of the Federal Reserve (which should have decreased the real tax rate on saving, and thus encouraged investment)
The reason JFK’s economic policy was so successful was because he kept taxes low, but simultaneously increased spending. A cursory knowledge of US Policy history would have you know that JFK increased spending on social programs, and the deficit grew under his term.
As for the obvious affinity to tax cuts that this shows, I am going to point out the obvious: If few are receiving income, then tax cuts are not going to have as much of an effect.
The reason that Ronald Reagan’s tenure was so successful economically was because of the oil glut that occurred during it, not because of supply side economics. This oil glut was mostly due to OPEC resetting their prices and because of the energy regulation administrations established under Jimmy Carter.
The 25 year boom that followed Reagan was due mostly to the Subprime Housing Bubble, itself a product of weak government oversight, and the easy money and low interest rates (aka. the inflationary policy) of Greenspan’s, a libertarian’s, control.
“It is inflationary” – No, it is not, and this is one of the reasons that Supply Side Economics is unsound. Inflationary policy promotes spending and lowers interest rates, thus allowing for economic relief in times of recession.
“It would cause crowding out” – This is true; prolonged deficits do cause crowding out, and the government has an economic responsibility to pay back its loans once the economy is doing well. However, during the period that is mentioned, the crowding out effect was not witnessed because of the easy money policies of Greenspan, whose money creation essentially bypassed the federal deficit and created money that firms could use.
“But the nation experienced great prosperity and economic expansion during the Great Moderation” – True, however, this was primarily due to the Housing Bubble, which in turn was caused by Greenspan’s easy money policies and emphasis on securitization.