What Went Wrong: A Supply-Side Critique of the Early 21st Century

This past week, Professor and ex-Treasury Secretary Larry Summers sounds an alarm about the current state of economic growth (or lack thereof) in the Washington Post. Unfortunately, it is nothing more than the same Keynesian platitudes we have heard from the left and center-left for decades. Summers doesn’t even bother with a specific policy proposal, instead simply all but shouting “spend more taxpayer money!”

Of course, this is what we have come to expect from Keynesian economists. What we have yet to see is a detailed response from its critics – save swivel-eyed shouts of “Greece!” or other comments that are largely based on the old deficit-phobia that never went far with economists…or voters, for that matter. In particular, supply-siders have been mostly quiet on the events of the new century. They – or to be more precise, we – shouldn’t be, for events since 2000 have more validated the incentive-driven school than is recognized.

In this post, yours truly will examine the early 21st Century from the supply-side perspective: examining what went wrong and how to make things right. It begins, frankly, with an acknowledgement of a mistake.

The past: temporary tax cuts, a regulatory mistake, and a disconnect in the Special Relationship
Perhaps one of the reasons supply-siders have been quiet is the Bush tax cuts of 2001-3, which came right out of our playbook. We hoped that the reduced cost to businesses and higher profit incentives would spur investment as it did in the 1980s. It didn’t quite happen this time. The key difference here, however, was that the tax cuts were set to expire – a mistake that turned the aughts tax reductions from 1980s redo into late-1960s redux (when Lyndon Johnson tried temporary tax cuts which backfired). Without permanence, tax rate reductions lose their long-term incentive effects. Looking back, it would have been wiser to reduce the size of the rate reductions to win over enough Democrats to make them permanent.

Now, that was far from all that went wrong in the Bush era, but it should be noted that the three largest fiscal policies that Bush implemented (the temporary tax cuts, Medicare Part D, and the wars in Asia) were right from the Keynesian playbook on stimulating aggregate demand. Forget “broken windows” – from an economic perspective, war is literally making windows for the precise purpose of breaking them. More Keynesian stimulus? That wasn’t just a failure in this decade, but in the last one as well.

As for regulation (which even Summers admits is making it harder to acquire capital these days), most Keynesians assume the increased regulation we have now is a necessary consequence of preventing a repeat of the 2008 panic. Unfortunately, the assumption behind that is wrong. It was not a lack of regulation that led to the crisis, but rather incorrect regulation (the mark-to-market fiasco which created so much artificial red ink in the first place) combined with lax regulators in London (who completely ignored the Fed’s repeated warnings about the LIBOR rate chicanery).

Thus, when the Bush and Obama Administrations set about to cure what ailed the economy in 2008 and 2009, they misdiagnosed the patient, leading to the wrong solutions.

The present: asset inflation, wealth inequality, and governments showing their age
It never ceases to amaze me that so many on the left complain about inequality without acknowledging the role of the Fed and TARP (a.k.a., the bank bailout) in exacerbating it (to be fair, one of the few visible TARP opponents on the left is Bernie Sanders). Congress appropriated more for the bank bailout ($700 billion, although only $427 billion was spent) than on Medicaid and Unemployment Insurance combined in FY2009 ($371 billion according to the Congressional Budget Office). Meanwhile, Quantitative Easing dramatically raised the prices for debt-based assets (otherwise known as “bonds”) around the world – falling asset yields mean higher asset prices. This asset inflation led to two things: wealth inequality became worse, and asset holders now had artificial gains in their bond holdings, reducing their incentive to accept risks. Yet somehow, Keynesians never even notice these effects, as they only seem to assume that inflation can occur in product markets. Thus, so many economists ignore the inflation right in front of them.

Now, as bad as all of this is, an economy with sufficient mobility and a dynamic government can handle and address these concerns. Thanks to outdated, 20th Century thinking, we have neither. “Human capital” (or labor productivity, if you prefer) is dependent upon government mini-monopolies in education that are as effective and responsive as monopolies anywhere else. Infrastructure is dependent upon a system where fuel efficiency increases demand (by allowing for more miles driven) while decreasing supply (by reducing fuel consumption and the revenue from its taxes). Other sectors are caught in an intervention loop where the buyer end up funded by the government to counteract the seller’s government funding (food stamps to counter agriculture price supports, Medicare and Medicaid to counter the government’s decision to hand pricing authority to the AMA, etc.).

The future: An Incentive-Based Government
As supply-siders, we have focused largely on taxes and regulations in discussing the incentives for businesses to produce, expand, and profit. But we can take incentives beyond that in discussing how to truly fix what ails the economy, rather than throw more money at the problems and hope they go away.

The usual: reduce tax rates and eliminate one-off credits. Yes, it’s been done before, but it has also succeeded before, and it can again. However, we need to “go long” rather than “go big.” If the politics demand smaller rate reductions to make them permanent, we should take the small reductions.

Inequality – stop the government from making it worse. We can argue for years (and in fact, we have argued for years) about whether government should alleviate income inequality. We should agree that government shouldn’t exacerbate it. Ending nonsense like agricultural price supports, the Export-Import Bank, and other Sheriff-of-Nottingham policies should top the to-do list. That also means reversing Quantitative Easing, deflating the asset bubble, and force investors to earn a more honest living.

I should bring up the minimum wage. Many want it raised, and their hearts are in the right place, but the incentives are all wrong. Increasing the Earned Income Tax Credit, by contrast, will lead to higher after-tax incomes for the working poor without making it more expensive for businesses to hire them. Again, it’s about getting the incentives right.

Decouple entitlements and transportation from their outmoded funding streams. The payroll tax will soon be unable to sustain Social Security (and it can’t handle Medicare as it is). Shifting the funding source could make means-testing easier (although we need to be careful there) and allow payroll tax reductions to incentivize more hiring. As for transportation, it can’t be tied to a slowly disappearing funding stream. Moreover, as normal federal revenues tend to be driven by economic performance, moving transportation out of the fuel tax cul-de-sac could make road funding more sustainable and more dynamic at the same time.

End the government near-monopoly on education. In a perfect world, governments could shift from being providers of public education to regulators of wholly private education. We’re not living in that world, but greater competition to the government mini-monopolies (and among them) can lead to better performance all around. No need to put all the eggs in one basket: public school choice, charters, “vouchers”…any and all can be used.

Note I did not discuss overall government spending, and for a reason. The need to make government more efficient (not just efficient at what it does, but in no longer doing what it shouldn’t) is very important. However, you can have a very efficient, perfectly constitutional government and still have outdated policies with the incentives badly wrong. Moreover, much of these policies will encourage economic growth and thus reduce the need for government spending and other intervention in the first place.

These things can’t be accomplished overnight. After all, it took at least 15 years of mistakes to get us here. But they can be done – and I’m optimistic (or naive) enough to think they can still be done despite our deep partisan divisions in America.

Either way, it has to be better than trying the same medicine that failed in the 1970s, in the early 1990s, and in the early 21st Century.

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