More Than a Blip
It's a supply-side recovery.


The March employment report marked a turning point in the economy. Prior to its release there was a decoupling in the data — real GDP growth and employment gains didn’t match up. Those who were partial to President Bush’s economic program argued that the recovery was for real and that low employment gains were due to high workplace productivity. More, they argued that if the economy continued expanding the employment gains would follow.

In contrast, the critics argued that last year’s surge in real GDP growth was a mirage — a blip that could be largely explained by the surge in defense spending. Their implication was that the economy would roll over with the drop-off in spending. The critics also argued that low monthly employment gains confirmed the view that the surge in economic activity was not sustainable.

Both sides placed their bets on the employment report. In fact, I argued that we were only one payroll report away from a major market rotation. That report finally came at the end of March; a jobs gain of 308,000 rocked the markets. The report has also, once and for all, settled the recovery debate: This economic recovery is for real and stronger than most people expected.

Although there may be some dispute as to the origins of the resurgence of the economy, there is no mistake as to the timing and the acceleration of the pace of economic activity. Real GDP grew at 1.97 percent during last year’s first quarter, 3.09 percent during the second, 8.2 percent during the third, and 4.14 percent in the fourth. In spite of the acceleration of economic activity, U.S. inflation came in at a modest 1.8 percent with core inflation at 1.1 percent — the lowest in 40 years.

The cause of the recovery, however, remains something that economists love to debate, but it is clear that the war in Iraq and the passage of the Bush tax-rate cuts (as well as an accommodative Greenspan Fed) had a lot to do with it. It is quite interesting that both Keynesians and supply-siders agree on the importance of the war and the tax cuts on the resurgence of the U.S. economy — however they do so for different reasons.

Within the textbook Keynesian model, government spending and tax revenues are two sides of the same coin. One increases aggregate demand; the other reduces it. Hence, increases in defense spending and tax cuts are alternative ways to stimulate aggregate demand. Since both war and tax cuts increase demand in the economy, it follows, within the Keynesian framework, that the two have had a hand in the past year’s surge in economic activity.

Supply-siders argue this much differently. They contend that lower tax rates increase the incentives to work, save, and invest. As Bush lowered tax rates, Americans worked more, saved more, and invested more, putting the economy back on track.

So, while the separate schools specify two distinct mechanisms by which government actions affect the economy, it is apparent that both agree on the simulative effects of the government actions. But the conceptual differences between the schools remain very important.

Within the Keynesian model, the revenue impact of a tax is all that is needed to determine its impact on the economy. It does not matter in this scheme whether a tax rate is temporary or permanent, only the magnitude matters. This is quite important (lawmakers wrestling over whether or not to make the Bush tax cuts permanent should take note). If no allowance is made for the disincentives of higher tax rates, the effect of a rate change on the tax base is assumed to be nonexistent. This thinking is what gives us static revenue estimates.

The simple Keynesian framework also does not take into account government budget constraints. Deficit-financing implies future tax liabilities; a forward-looking taxpayer would anticipate future taxes, negating the aggregate-demand effects that Keynesians claim deficit-financing generates. Supply-siders counter that there is no income effect once one takes into account government budget constraints. All that remains is the substitution effect, or incentive effect, that the Keynesians ignore.

The simple discussion of income and substitution effects allows one to set up a simple test as to the source of the recovery. Economists who emphasize the impact of the war effort on the economy’s aggregate demand forecast a much slower economy when the spending subsides. Those who focus on the incentives of the Bush tax-rate cuts point out that the effects of those rate cuts are longer than a one-year horizon.

Hence, the Keynesian model predicts a temporary blip in economic activity that subsides with the drop in defense spending, while the supply-side model argues that tax-rate cuts provide a continuous incentive to save, invest, and produce. And here we are back in the spring, a year after the stimulus of war and tax relief went into effect, holding a March employment report indicating 308,000 new jobs.

Other indicators make the long-run, bullish economic picture even clearer. The November industrial production index had its strongest increase in four years. Accelerating capital-goods investment provided the catalyst that led the ISM index to post a twenty-year high. Business investments, meanwhile, are turning progressively stronger.

The trend in productivity gains is partially responsible for the slow employment recovery, yet all indicators point to significant increases in employment during the coming months. But the latest payroll gain clearly supports the view that this economic recovery is for real — as the supply-siders have argued all along.

– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.


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