An article in the Wall Street Journal [published in March 2000] by the chairman of the president’s Council of Economic Advisers, Martin N. Baily, shows that much of the economics profession is stuck in clichés and out-of-date economic thinking. Baily tries to claim that the long expansion set off by President Reagan’s cure of stagflation is really two separate expansions, with the second expansion – President Clinton’s – being superior to President Reagan’s.
This spurious claim is part of President Clinton’s effort to create a legacy for a scandalous, and otherwise pointless, administration.
In Baily’s crude macroeconomics, there are two variables: government-induced demand and interest rates. President Reagan’s expansion in the 1980s was second-rate, Baily says, because it “was heavily driven by the stimulus of government-induced demand” from “fiscally irresponsible tax cuts” that increased the national debt, raised real interest rates and killed the economic expansion.
In contrast, President Clinton’s expansion is based in “fiscal discipline” and budget surpluses that have lowered real interest rates.
The problems with Baily’s claims are obvious.
First, if the long expansion of the 1980s was based on deficit spending, how was it possible in Baily’s demand-side economic framework for inflation to fall so dramatically over the course of the expansion?
When President Reagan began in office, inflation was measured in double-digits. Economists of Baily’s ilk maintained that output could not increase without inflation rising higher. President Reagan’s tax cuts, they said, would be wildly inflationary, because they would over-stimulate demand in a period of high inflation.
Baily’s brand of economics is wrong because it misunderstands the purpose of a reduction in tax rates. President Reagan’s expansion was based on changing the economic recipe. Instead of stimulating demand with easy money, while killing output incentives with high marginal tax rates, Reagan’s supply-side recipe relied on tight money and improved after-tax incentives.
President Reagan’s new recipe killed stagflation and banished the “Phillips curve” trade-off between economic growth and inflation. A historic expansion unfolded while inflation declined.
Second, President Clinton inherited a fundamentally improved economic environment. He and his advisors did not have to contend with double-digit inflation, a traumatized bond market or a Federal Reserve that saw the specter of inflation in every increase in employment.
Reagan slayed all these dragons. All President Clinton had to do was coast.
Even this proved challenging for Clinton, who raised taxes to grab more money for Democratic constituencies. But the tax rates remained far below the pre-Reagan 50 percent and 70 percent rates that had killed productivity and output growth. Moreover, as inflation continued to decline, the increase in the real values of business depreciation allowances offset the adverse effect of the Clinton tax hike.
Like Martin Feldstein before him, Baily has not caught up with the work of Nobel prizewinner Robert Mundel. Both Feldstein and Baily made the embarrassing mistake of assuming that capital markets are domestic, not global, and that budget deficits can only be financed out of domestic saving.
Baily also makes the extraordinary admission that President Reagan’s expansion took place despite real interest rates 50 percent to 90 percent higher on average than in the current expansion. As Baily himself says that President Clinton’s expansion is based on lower real interest rates, he acknowledges that President Clinton’s expansion would not have occurred without them.
Yet the substantially higher real interest rates did not prevent President Reagan’s long expansion.
If interest rates are as important as Baily thinks, clearly President Reagan had something more powerful working for him. He did. It was the changed recipe provided by supply-side economics.
It is the changed economic policy recipe that makes the 1980s and 1990s one long economic expansion. The expansion was briefly interrupted in President Bush’s term, but the pause had nothing to do with interest rates or national debt.
The slowdown was caused by uncertainties over the Gulf War, fears of a second “oil shock” and concern that Bush’s breaking of his “no new taxes pledge” might signal the abandonment of Reagan’s successful economic recipe.
The economics establishment has been challenged three times in the postwar era: first by monetarists, then by rational expectations and lastly by supply-siders. Each time, the Keynesian establishment lost the debate. Keynesians continue to peddle their snake oil because the real function of their “economics” is to justify Big Government and the redistribution of income.
Paul Craig Roberts
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