The debate in Washington over President Bush’s tax cuts is frankly an intellectual scandal. The president’s tax-cut package, now pending in conference, has been proposed to stimulate the lethargic economy. Opponents of the tax cut have argued that by increasing the deficit the tax cut will actually harm the economy, or at least fail in it’s goal of reviving robust economic growth.
What should be shocking is how at odds this opposition argument is with all schools of economic thought, and everything taught about economics in our nation’s colleges and universities.
Since the 1930s, the reigning theory regarding the performance of the macro economy has been Keynesian economics, named after British economist John Maynard Keynes. Under Keynesianism, when you want to stimulate the economy you run bigger
deficits, which pump up demand for goods and services, leading to greater output. On this theory, reducing budget deficits or running budget surpluses is a drag on the economy, reducing demand and output. This theory, of course, supports the president’s tax-cut proposals, as the tax reductions will supposedly pump up demand, and more output to satisfy it.
For four decades, the liberals and Democrats ballyhoed the brilliance of Keynesian economics to justify increasing spending and deficits. Conservatives and Republicans opposed to these policies were just uneducated troglodytes, they said.
But not much has been heard about Keynesianism since 1980. That is because when the conservatives and Republicans embraced tax cuts over balanced budgets under Reagan, Keynesianism no longer served as an excuse just for deficit spending. Now it bolstered the case for tax reductions, which also seemed far more politically potent than more spending.
The liberals and Democrats, however, desperately need all the tax revenue they can get to fund their spending dreams, and to feed the political machine based on that spending. So the moment Keynesianism seemed to work politically in favor of tax cuts rather than more spending, the same people who had trumpeted the theory for four decades as the intellectual foundation of sound economic policy dropped it down the memory hole.
Yet, Keynesianism is still taught in our colleges and universities as the foundation of macroeconomic theory, and most practicing economists still think of it that way. It still dominates the textbooks used by university students, though the newer and better books express some skepticism about it and discuss the alternatives more favorably than in the past.
Conservatives never believed in Keynesianism. The monetarist school of thought, led by Milton Friedman, argued that deficits do not add to overall demand and, therefore, do not stimulate the economy. The monetarists argued that whatever spending and demand is put into the economy by deficits is taken out of the economy when the government borrows to finance the deficit. The monetarists, therefore, argued that deficits were ineffective in stimulating the economy. But they did not argue that deficits would drag the economy down into recession.
The monetarists argued that short-term stimulus may be achieved by increasing the money supply and reducing interest rates through Federal Reserve policy. But they argued that over the long run excess money growth would just cause inflation rather than more real growth. Over the past year and a half, the Fed has done just about all it can to stimulate the economy.
The supply-siders came along around 1980 and argued that the right kind of tax cuts — those providing greater incentives for more saving, investment, work, and entrepreneurship — would stimulate the economy, even if they produced greater short-term deficits. The record of the 1980s seems to show that this theory worked spectacularly in saving the U.S. economy from what was truly its worst crisis since the Great Depression.
This theory, of course, strongly supports President Bush’s tax-cut proposals, though some of the proposals in the package do not significantly enhance incentives. These components, like expanding the child tax credit, are based on social policy arguments instead.
Supply-siders have been advancing in academia over the past 25 years. What was once a toehold is now a beachhead. Many if not most monetarists embrace supply-side reasoning as well, as it does not contradict the tenets of monetarism, and is more consistent than Keynesianism with the longer history of neoclassical microeconomics (the study of individual economic behavior).
But nowhere today, or in economic history, will you find an intellectually developed school of thought that says tax cuts that increase deficits will cause an economic downturn rather than an economic rebound. Even Marxism doesn’t say that. To the contrary, such an argument flies directly in the face of the still dominant school of economic thought, Keynesianism — which liberals had long embraced as the fount of economic wisdom — not to mention the newer supply-side school of economics.
The argument also flies in the face of economic experience. The president’s critics argue that the tax cuts will cause higher deficits, which will cause interest rates to rise, slowing the economy further. But deficits soared in the 1980s. At the same time, interest rates dropped dramatically from their peaks in 1979 and 1980, when the prime rate actually hit 21 percent. Moreover, even while those deficits rose, the economy boomed in the 1980s, as has been thoroughly documented elsewhere.
Similarly, in the past few years, the federal budget shifted dramatically from large surpluses to large deficits. Yet, interest rates have dropped dramatically during that time as well.
The conclusion is inescapable. Both economic reasoning and economic experience establish that the president’s tax-cut proposals should be enacted to stimulate the economy. That is why they are going to be, over the opposition of the Left, which has long since forgotten everything it once thought it knew about macroeconomic policy.
The real reason liberals are against the tax cuts has nothing to do with the deficit or sound economic policy. They just want as much tax revenue as possible so they can increase spending and feed their political machine.
— Peter Ferrara is director of the International Center for Law and Economics and president of the Virginia Club for Growth.