Voodoo Economics, Part 2

In my last post – Voodoo economics – I hit my page limit before I got to any real specifics. I laid out a rationale for why demand-side policy probably was largely spent and gave some background on supply-side policy. The main point is that supply-side policy has a checkered reputation that is mostly undeserved. It is pretty easy to dispense with the charges that it won’t work or that it is trickery. The more difficult aspect is that supply-side policy generally works BECAUSE IT STARTS by impacting rich folks and business firms.  But what matters most is where it ENDS – so let me get on with that point.

If you are imbued with equity and making sure that all people are always treated equally then you may find supply-side policy offensive. If you HATE capitalism and think that most capitalist policies are part of a great hoax that perpetuates current power and wealth, then you are probably not going to trust supply-side policy. If you are simply hoping to find a policy that will help us permanently exit this horrible recession and slow growth period, then you will want some assurance that any policy will do what it is supposed to do – create more economic prosperity and jobs. So where is the beef (or tofu for my vegetarian friends)?

Keep in mind that every policy is uncertain and risky. The Fed’s new quantitative easing policy is hotly debated. Another round of short-run government stimulus is no slam dunk and has its supporters and detractors. Supply-side policies are no different so let’s not read what I say here as blue-sky advocacy.  In my previous post I made the point that supply-side policy works because it directly impacts those who do the hiring and produce the output. The supply-side policy is directly aimed at business firms’ bottom lines. The basic intuition is that if policy can somehow make business executives more optimistic about their future revenues and costs, then they will be more willing to make capital investments and hire more workers.

Of course, like all policies, supply-side policy has its own moral hazards and unintended consequences. So we shouldn’t throw the baby out with the dirty bath water. Whatever advantages are given to companies and high income investors, attention must be paid to how they will translate into jobs and economic growth. I have said many times that I am neither a democrat nor a republican. Adam Smith was very clear that while he favored letting the invisible hand work, that firms are just as capable of corruption and waste as governments. While supply-side immediate impacts must be directed to firms and higher income investors – the true value of this approach is in its ultimate impacts in terms of higher output, more employment, and higher incomes.

What I didn’t do in the last post is to discuss the many ways this can be done. Notice that even among supply-siders there can be very different preferences for specific policies. Much depends on what you think is the biggest problem – what is making firms less willing to use their piles of cash today? What is making them less willing to make capital investments? Why don’t they hire more workers?

For starters, imagine one group of supply-siders who believe the economy is on the mend. They believe that we got hit by an economic firestorm that rocked our economic foundations but that the resilience of the economy provided the foundation for recovery and the policies of the last two years did not prevent some early healing. These supply-siders point to various green shoots or data that show promise of a continued recovery. Their supply-side recommendation might be – Don’t rock the boat! They might advise the government to create as little change as possible.  Just let the economy continue to heal. Firms will jump in as soon as they are surer that this recovery really has legs.

Of course, another group of supply-siders might believe that government policy was too aggressive and that we have created a very risky business environment typified by too much government debt. We all have seen some really worrisome estimates of future debt burdens. They bring up scenarios in which the US becomes the disdain of world investors causing a plummeting dollar, declining stock prices, and rapidly rising interest rates. It is not a pretty picture. These supply-siders believe that you can reduce the risky environment by paying attention to imbalances in the balance sheet of the Fed and the large liabilities of the government. Firms will not hire workers in sufficient numbers until they believe government debt and Fed policy are under control. Their supply-side policy means significant changes in the government budget and Fed policy.

Other supply-siders worry about international competitiveness. They worry about a government that seems to give lip service to free trade and a strong currency but whose real actions seem to put off the real decisions about trade or they lead to a declining value of the dollar. Whether it was the recent Asian Summit or the G20 meetings, the US was able to accomplish little. We have stalled so long on bilateral free trade agreements that our potential partners now seem to be the ones dragging their feet. The US harps on about China’s currency when most people agree that the US is equally culpable. Geithner blames the recent spectacular declines in the dollar on a reversal of safe monies. But what does he think caused the “new” view that the US is an unsafe place to invest? Keep in mind that while dollar declines might help exporters – they do very little to improve the competitiveness of US importers and they accelerate the desire of foreign investors to move their money out of the US. If you were a foreign investor, would you really want to receive your future return in dollars that are worth 15% less?  Real free trade and a real strong dollar are not easy to buy today. But they are an indispensible part of a strong and viable supply sector. 

Most discussions of trade end up with a story about saving. We all know by now that the US saves too little – and therefore our imports end up rising faster than our exports. This implies a need to borrow from the rest of the world – and we do. It is pretty clear that we in the US need to save more and our trading partners could save a little less. But who does saving in the US? Short answer – rich people and companies! The only real way to increase saving in amounts that matter is to increase the reward to saving. A Fed policy aimed at zero interest rates does nothing to help! A threatened increase in income tax rates and capital gains tax rates does nothing but reduce the incentive to save. Opponents of lowering these rates always point to the disproportionate benefits that would go to rich people. But notice that their focus is on the immediate impacts. Instead they should trust that a country with normal or strong saving more easily channels resources for innovation and labor productivity without having to borrow from abroad. Saving is the key to economic growth and rising incomes.  The ultimate effect is the one we should be focusing on today.  Thus some supply-siders advocate lower tax rates for companies and households regardless of income.

I am getting too wordy again and I have only discussed four examples of supply-side policies. I don’t want to promise a Voodoo 3. There are so many other great topics to be talking about!

So let me just summarize the rest briefly. Another approach to supply-side policy focuses on the reward to produce and the reward to work. While the US used to have a reputation of a country with a small government and low taxes, this is no longer the case.  Whether it is taxes on energy or regulations that require firms to guarantee health care or be greener it is no secret that firms feel increasingly burdened by government. Given the inertia of the government, firms are also increasingly uncertain as to how these new regulations and taxes will impact their future net revenues.  Add to that a worry that current unflattering attitudes toward the rich and corporations raise expectations about higher taxes on the incomes of companies and high income individuals. A supply-side approach recognizes how counterproductive this environment is to economic growth and employment.

Several leaders of the Democratic Party have very recently pointed out that postponing increased tax rates for the rich is the fair thing to do. They also are holding social security out of any discussions of how to solve long-term government debt challenges. Again, the issue is fairness. But what does fairness mean? I really doubt that dragging our feet on needed policies for economic growth is going to have an impact on the rich or the poor. The rich will take care of themselves at the country’s peril. The problem of poverty has little to do with marginal tax rate changes and everything to do with very long-term factors involving sociology, education, and training.  All government policies should not be held hostage to fairness. The fair thing to do is to take a very comprehensive and realistic view of poverty in the US – and then do something about it. 

Supply-side policies deserve a good look. There are many ways to skin this cat. But we won’t get to the first step if we can’t get beyond the Voodoo.