Reprinted from Paul Craig Roberts
I have often expressed my admiration for Warren, Prins, Martens, and Hudson. In his latest column, David Stockman has earned my admiration and forgiveness.
I say forgiveness because in my opinion Stockman came close to sabotaging President Reagan's economic program.
None of us on whom the president was relying expected that Stockman would be the weak link. Stockman, a member of the House, was an advocate of the new policy and a friend of U.S. Rep. Jack Kemp. I knew Stockman and had worked with him in putting together a new approach to economic policy in the short time between the November election and January inauguration.
The success of the new policy depended upon Stockman, who we managed to have appointed Director of the Office of Management and Budget, on Federal Reserve Chairman Paul Volcker, and on my office in the U.S. Treasury where I was appointed Assistant Secretary for domestic Economic Policy.
The problem we confronted was the worsening "Phillips curve" tradeoffs between inflation and unemployment that had produced a situation termed "stagflation." The Phillips curve illustrated that an increase in employment had to be "paid for" by accepting higher inflation, and a reduction in inflation had to be "paid for" in terms of higher unemployment. The trade-offs between inflation and unemployment were worsening. The dilemma came to a head when Milton Friedman showed that the Phillips curve trade-offs had broken down and that higher inflation now brought higher unemployment.
The new situation was described as "stagflation." The Keynesian macroeconomists and policymakers could not explain the cause of stagflation and had no remedy.
Supply-side economists had both explanation and remedy.
The battles between Keynesians and supply-siders had been fought in the Congress over the previous five years. Republicans in the House and Democrats in the Senate had been won over to the new policy. In the annual budget resolutions, the Republican minority in the House offered a supply-side approach to the traditional Keynesian approach. In the Senate the Democrat majority endorsed the supply-side policy in the annual reports of the Joint Economic Committee, the chairman of which was Lloyd Bentsen. Finance Committee Chairman Russell Long was on board with the new policy, and Sam Nunn actually got the policy passed only to see it killed by the Carter administration.
I have explained many times the difference between a Keynesian and supply-side approach. Essentially, it comes down to this: In Keynesian macroeconomics, monetary and fiscal policy operate only on aggregate demand (the total demand for goods and services), not on aggregate supply. Monetary and fiscal policies cause aggregate demand to increase or decrease. For example, an income tax rate reduction (fiscal policy) raises consumers' after-tax incomes and results in higher consumer demand.
In contrast, supply-side economics emphasizes that a reduction in marginal tax rates alters the relative prices that determine the price of leisure in terms of foregone current income and the price of current consumption in terms of foregone future income from saving and investing.
In other words, a reduction in marginal tax rates makes leisure and current consumption more expensive in terms of foregone income and results in an increase in labor supply and an increase in saving and investment. Thus, the policy increases aggregate supply.
Not realizing that fiscal policy affected aggregate supply, the Keynesian policymakers increased aggregate demand with easy monetary policy but restricted the response of supply to the higher demand with high tax rates. The result was stagflation.
The solution was to reverse the policy mix: a tighter monetary policy (less new money creation and a reduction in demand pressure on output) and lower marginal tax rates (a rise in supply or output). The result would be a repudiation of the Phillips curve. The real economy would grow while inflation fell.
New policies are always at a disadvantage. For example, a new economic policy depreciates the human capital of economists and financial journalists associated with the former policy. Leadership passes from an established order to a new one. Journalists have to retool. It amounts to a lot of work and inconvenience.
As Niccolo Machiavelli declared: "There is nothing more difficult, more perilous or more uncertain of success than to take the lead in introducing a new order of things."
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