Brief History of Macroeconomics and The Origins of Freshwater vs. Saltwater Economics

I and others, particularly Paul Krugman, occasionally make reference to “freshwater” vs. “saltwater” economics.  Here’s a little background to explain the terms and, I hope, shed a little light on current disputes in macroeconomic theory.

First, let’s go back in time.  The stuff that economists study, namely the economy, economic behavior, and markets, really emerged as it’s own discipline in the 1700’s with Adam Smith.  It had always been a topic for philosophers to discuss. Even Aristotle writes about the topics.  But it didn’t really emerge from “moral philosophy” into it’s own field of study until Smith.  Originally Smith and the subsequent economists such as Ricardo focused on markets and what we now  call microeconomics with a nod towards questions of political economy (public policy and the whole economic system).  The industrial revolution was in full swing.  The economic system wasn’t really “capitalist” because nobody knew what that was yet.  It wasn’t until the mid-1800’s that the word capitalism becomes commonly used.   Note:  Adam Smith was not a capitalist.  According to the Oxford English Dictionary, the earliest recorded usage of “capitalist” comes in 1792 in France, well after Smith wrote the Wealth of Nations.  

Then in the years just after the Napoleonic wars, England suffered some very severe financial crises and depressions involving the collapse of canal-building businesses.  At the time, Smith’s famous treatise was now 40-55 years old.  The authors now called economists argued about it’s causes and the policies needed to right the economy and restore full-employment.  The center of the debate revolved around questions of “whether there could ever be such a thing as a general glut of commodities”.  In other words, was it possible that the now industrialized economy with it’s newly enlarged banking sector and wide circulation of paper money could be too efficient?  Would such an economy always produce willing buyers for all the goods that sellers wanted to supply?

Two views emerged. One of them, later called “Classical” becomes the dominant thinking in economic circles.  The Classical view denies that long-term high unemployment is even possible as long as the government balances it’s budget and follows a laissez-faire policy of not interfering in markets.  A very mechanistic view of the economy as being constructed of self-adjusting markets that always return to equilibrium evolves.  The Classical view supports a very liberal (old sense) and anti-regulation view of government policy.

Critics existed but they failed to dominate the debate.  Karl Marx in the mid-1800’s writes some scathing critiques of Classical economics focusing on how the mechanism of market equilibrium cannot and does not work as described in labor markets.  Yet despite the critique, the Classical economists continue to dominate policy making and academic circles.  The debate, however, becomes more polarized with the Classicals of the late 1800’s and early 1900’s pushing even more extreme anti-government, pro-market policy positions and models than their Classical predecessors advocated. Many of the critics of capitalism and Classical economics move to the opposite end of the spectrum and embrace socialist, communist, or fascist/syndical economics, in effect taking a position that market capitalism is so fatally flawed that it must be completely replaced by a system of planning by the government.

Despite the dominance of the Classicals, there were always some economists laboring, researching, and writing about the cycles of business and the workings of money and banks.  They just didn’t get much attention or have a comprehensive framework to distinquish themselves from either the Classicals or the planned economy types.

Then came Keynes and the Great Depression.  Classical economics denied The Great Depression could happen – much like University of Chicago economists in 2010 who claimed that today’s high unemployment is the result of workers suddenly choosing to voluntarily have leisure instead of a job.  Keynes writes a powerful book called The General Theory of Employment, Interest, and Money.  Macroeconomics is born.

Keynesian macro focuses on a total systems approach to the economy instead of just assuming that whatever works in a micro perspective in each market will make the total system work.  Keynes attempts to avoid the fallacy of composition. Keynes’s analysis shows that an industrialized, capitalist market economy with a financial/banking sector is inherently unstable.  It tends to have cycles – business cycles.  It’s beyond the intent of this post to explain the reasons, but the bottom-line was that Keynes identified a role for active government and central bank policy to maintain full employment  and stable prices.  Keynes rapidly gained converts in economics and soon the field was split into microeconomics and macroeconomics.

The success of Keynesian economists and Keynesian policies in the 1940’s, 1950’s and 1960’s led to dominance of Keynesian viewpoints.  But there were two subversive trends underway that would eventually reverse the Keynesian dominance and return the Classical viewpoint to dominance.  One was an attempt to build a comprehensive mathematics framework for all economics built on the math of Newton’s physics.  This effort, called the neo-classical synthesis, originally focused on microeconomics.  But eventually it turned it’s attention to putting Keynes’s ideas into the same optimizing-behavior mathematics.  Unfortunately, Keynes himself was long dead by now and unable to clarify what he “meant”.  Some ideas are forced onto him that weren’t necessarily there in the original (such as insisting on static equilibrium).  The second trend was a small group of economists who never agreed.  They were in effect Classicals in exile.  Led by Milton Friedman at University of Chicago and Friedrich Hayek, they launched a two-prong attack.  Hayek’s attack led to what we call Austrian economics today and is often embraced by extreme libertarians.  I won’t get into that here, there’s not enough time.

Friedman’s initial attack focused on re-writing our understand of The Great Depression.  Friedman works to show that monetary policy by the central bank was at fault for the Depression, implying that a laissez-faire government fiscal policy would be best.  Friedman’s disciples at Chicago and elsewhere expanded the attack by insisting on “micro-foundations” in all macro-economic theories and models.  By micro-foundations, they mean that the only acceptable basis for a macroeconomic model is one that is based only on the micro ideas of perfectly rational individuals acting on perfect information with perfectly rational expectations about the future and the nature of the economy.  By the mid-1970’s the Friedman posse was clearly winning the academic wars, in part because their position lent itself easily to using neo-classical synthesis  mathematics and because it was consistent with “micro-foundations”.

Friedman originally took a modified Classical position.  Classicals denied that either fiscal or monetary policy could affect or correct the performance of the whole economy.  Friedman pushed the idea that fiscal policy wouldn’t work but that monetary policy would.  Eventually the next generation of Friedman students and disciples went further and returned to the Classical position that neither fiscal nor monetary policy would work.

As it turns out, these newly re-ascendant Classicals, now being called New Classicals, inspired by Friedman, often taught at universities located inland near some kind of “freshwater”.  The remaining supporters of Keynesian viewpoints, now under severe attack, taught at schools nearer the ocean.  Then in 1976 R.E. Hall pens a paper called Notes on the Current State of Empirical Macroeconomics and identifies this split and associates freshwater and saltwater with the split.

As I see it, the major distinguishing feature of macroeconomics is its concern with fluctuations in real output and unemployment. The two burning questions of macroeconomics are: Why does the economy undergo recessions and booms? What effect does conscious government policy have in offsetting these fluctuations? These questions define the issues considered here. I will further restrict my attention to structural approaches, and will avoid discussion of the reduced-form approach, including its recent sophisticated manifestation (7).

As a gross oversimplification, current thought can be divided into two schools. The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity). The old division between monetarists and Keynesians is no longer relevant, as an important element of fresh-water doctrine is the proposition that monetary policy has no real effect. What used to be the standard monetarist view is now middle-of-the-road, and is widely represented, for example, in Cambridge, Massachusetts.

1To take a few examples, Sargent corresponds to distilled water, Lucas to Lake Michigan, Feldstein to the Charles River above the dam, Modigliani to the Charles below the dam, and Okun to the Salton Sea.


 

Obama’s So-Called Keynesian Stimulus Efforts Aren’t Very

The simple version of Keynesian economics suggests that if the economy is suffering from too little economic activity and high unemployment there are some policy options.  Specifically Keynes suggests there are three general kinds of policy options:

  1. The central bank (The Fed in the case of the U.S.) could lower interest rates and create money by buying bonds on the open market.  This is called stimulative monetary policy. It is supposed to work by making private sector borrowing more attractive and more profitable so that businesses in particular increase their spending on business investment goods like equipment and factories.
  2. The government could increase it’s budget deficit by borrowing more money and cutting taxes.  This is fiscal policy by tax cuts. It works by putting more cash in the hands of households and firms (increases their after-tax income) who then increase their spending.
  3. The government could increase it’s budget deficit by borrowing more money and directly spending the money itself, either by direct transfer payments to needy individuals, or by buying things like new dams or construction projects, or by hiring the unemployed itself. This is fiscal policy by spending.

There’s nothing to stop a country from pursuing all the above options simultaneously if it chose.  But not all of these options are equal in either effectiveness.

NOTE: This is old-style John Maynard Keynes style Keynesianism, not the  “New Keynesian” theories that have dominated some academic circles in the last couple decades. It’s also based on the real thing, not the caricature that it’s opponents paint which is usually without foundation. 

NOTE 2: It’s really not a good idea to try to simplify Keynes.  When you do, you’re likely to over-simplify and really miss powerful insights and nuances.  Nonetheless, I will plunge ahead with full knowledge of the risk.

The real richness of Keynesian theory though lies not just in these prescriptions, but the analysis of when to use which one, whether it is likely to work, and under what conditions.  The first option, monetary policy, is to be preferred in cases of  mild recessions when interest rates are “normal” and the slowdown is largely for mild, temporary factors such as an outside economic shock. Monetary policy is quick and easy to implement. It’s also relatively easy to reverse course when the time comes.

Keynes had two key insights about monetary policy though that are highly relevant to our present situation.  Monetary policy can be become impotent if interest rates drop to near zero and we get into a liquidity trap.  This is when people and firms become fearful of the future and come to expect continued weakness or even GDP declines and deflation.  In a liquidity trap, people just sit on money rather than spend or invest it.  Monetary policy is relatively ineffective in such cases. We have been in a liquidity trap since late 2008 and that’s why the record 3 years of a virtually zero Fed Funds interest rate and The Fed’s QE1 and QE2 programs haven’t worked. Liquidity traps aren’t common, but they do exist and they aren’t extinct.  We were in one in the 1930’s Great Depression and Japan has struggled with one for the last 15+ years.

Keynes also had insights about the two fiscal policy approaches, tax cuts vs. increased spending.   In particular, tax cuts will only be effective to the degree that households and firms actually spend the money.  If they use the money to pay down debts or to save, then it really won’t improve conditions.  Later research in the 1950’s and 1960’s strengthened these insights. Later research showed that it also makes a big difference who gets the tax cuts and whether they think the tax cut is permanent.  Temporary tax cuts are much less effective than permanent ones because people tend to save them more.  Also, high-income individuals tend to save more of the tax cut (proportionally) than more desperate lower-income folks. Finally, later research showed that when a recession comes about because private debt got too high, then tax cuts are least effective.  Notice a pattern here?

The fiscal policy “stimulus” efforts that we have pursued since the Great Recession began have been very, very heavily tax-cut oriented.  Bush’s original stimulus effort in early 2007 in an effort to “nip the recession in the bud” was all tax cuts.  The Feb. 2009 stimulus bill of Obama (the ARRA) was between 40% and 50% tax cuts.  The meager effort passed in Dec 2010 was all tax cuts. And now, the proposal is again very tax cut heavy.  Not only have the fiscal stimulus efforts been heavily tax cut-based, but the cuts have temporary cuts targeted at either high-income folks or only offering a meager amount to low-income folks.  Further, we still have a huge private sector debt overhand that people want to pay down before they spend more. In sum, the dominant response which many have labeled as “Keynesian” really hasn’t been what John Maynard Keynes suggested. Many have asserted that “Keynesian policies don’t work” and cite our weak economy despite several fiscal policy stimulus attempts as proof.  But that’s not really a valid test.  It’s like claiming some physician is a total quack because you took pills like he recommended but you didn’t take the exact same pills as he recommended. You took something else. Now you’re still sick.  It’s not the physician’s prescription that failed, it’s your refusal to follow the prescription and the diagnosis that failed.

Critics will counter with a “yes, but there was still some spending stimulus in the Obama bills and our failure to fully recover is proof the fiscal spending as stimulus prescription is quackery.”  But have we really had an increase in government spending anywhere near large enough to fill the gap?   Let’s look at some trends (courtesy of Brad Delong):

We simply have not expanded government purchases as a share of potential GDP in this downturn:

FRED Graph  St Louis Fed 4

 

The graph shows the relative changes in share of GDP of four key portions of GDP: exports, business equipment investment, government purchases, and residential construction. (everything in the graph is scaled relative to 2005 -that’s why the lines all meet at o in 2005).  The whole Keynesian idea is that if exports, business equipment investment, or residential construction go down then government purchases should go up and vice versa.  That hasn’t happened at all.  Instead, government purchases has consistently declined since 1995!.  In other words, actual changes in government purchases have not only not been a stimulus, but they have been contractionary.  Government spending policy has been contractionary for over 15 years!  We didn’t notice it because strong increases in business equipment investment and housing were doing the stimulating prior to 2006. In the period 1995-2000, it was probably appropriate in a Keynesian sense to have declining government purchases and a contractionary policy – it was countercyclical to the dot-com boom and the housing boom.

But after 2007, residential construction collapsed. For awhile in 2009 both business equipment investment and exports declined sharply.  The only appropriate Keynesian response would have been a very, very large government purchases program.  But we didn’t do that.  Instead, the so-called 2009 stimulus bill was barely enough new spending at the federal level to offset the declines and cuts at the state and local levels. Overall, government spending did not increase. It went neutral for a couple years. But in late 2010, we resumed the march to contractionary policies.  The ARRA wound down.  State and local governments accelerated their budget cuts. And Washington became pre-occupied with imaginary threats of impossible debt crises at some point 10 years from now.

To continue the earlier physician and disease metaphor, we did try a little of the prescription but we took too little.  It’s as if we went to the doctor, the physician diagnosed a very severe infection and prescribed heavy doses of anti-biotics.  We went home took a lot of aspirin instead and only a couple of the anti-biotic tablets.  Now folks want to blame the doctor and his “failed prescriptions” when we didn’t take them.  None of this is what Keynes or 1960’s style Keynesians would have recommended. To conclude that Obama has tried Keynesian policies and they have failed is dead wrong.  The policies have largely failed to stimulate and re-ignite growth, but they weren’t Keynesian.

What a Liquidity Trap Looks Like in Pictures

I want to follow up a little on my discussion of the liquidity trap that we are have been in. Brad Delong has an excellent post today called “Four Years After the Wakeup Call”.  In it he shows some graphs which illustrate very well our the liquidity trap.

Delong first serves us two graphs on the Federal Funds rate since early 2007:

The daily gyrations of the usually-placid Federal Funds market starting in late 2007 told us all that banks were really worried that other banks had jumped the shark and turned themselves insolvent.

FRED Graph  St Louis Fed 7

 

The Federal Funds rate is the interest rate that banks pay to each other when they borrow reserves from each other.  Despite the name, the rate isn’t set by The Fed. It’s set by market supply-and-demand.  It’s a large and brisk market.  When the Fed Funds rate is high (or at least rising), we can infer that banks need and are desperate for reserves, typically because they have profitable opportunities to make loans based on those reserves. When The Fed Funds rate is low and/or dropping, it means that a lot of banks have excess cash on their hands and don’t see any useful or profitable ways to use that money. In other words, a low Fed Funds rate means banks are willing to lend their reserves to other banks because it’s better than nothing and they don’t see any good ways to loan out the money. At the same time, a low rate also shows that few banks are interested in borrowing – again because they don’t see much useful to do with it.  While The Federal Reserve doesn’t set the funds rate, it does set the interest rate for the alternative: direct borrowing from The Fed.

What we see from the first graph is that things were cruising along in early 2007 and then mid- to late 2007 (August to be exact), the rate starts dropping.  We’re moving toward a recession.  Banks are finding it harder to make good loans so they don’t want to borrow more reserves.  Banks start hoarding their cash and assets.  So instead of balance sheets that are full of loans, bonds, and securities, the banks decide they want/need more cash.  Their reserves grow in order to provide a cushion for what was then being seen as the inevitable losses on mortgages and mortgage securities.  Things appear to stablize and then in Sept 2008 comes the Lehman moment.  Fed Funds rate goes virtually to zero.  It’s been stuck there ever since.  Banks have plenty of reserves. They have the cash to lend.  There’s no willingness to lend (banks don’t see many credit-worthy borrowers) and there’s little interest or demand to borrow.

The Federal Reserve has responded during the same period by creating new base money like crazy.  [NOTE: Contrary to the fears of the inflation-fearful crowd, it’s not really “money” until it’s in circulation with the public. It’s only bank reserves – the monetary base.  It creates the ability to create money for the public, but that would necessitate having a bank lend it first. ]  Again Delong shows up graphically just how The Fed has been willing to create new monetary base:

And while the Federal Reserve has taken the monetary base to previously-unimaginable levels–up from $900 billion to $1.7 trillion in late 2008, up to $2 trillion in let 209, and up to $2.7 trillion in early 2011–it has never adopted Milton Friedman’s recommended policy that it start buying bonds for cash and keep buying bonds for cash until nominal spending is on the path that the Federal Reserve wants it to be on:

FRED Graph  St Louis Fed 5

We only need one more graph: GDP.  More precisely a comparison of GDP to an estimate of what GDP could be if we were at full employment and operating at our long-term trend.  Again Delong:

And so right now nominal GDP is $15 trillion/year when it ought to be $16.7 trillion/year:

FRED Graph  St Louis Fed 6

I’ll save inserting the employment graph here.  I’m sure you all know what it looks like. Same story.

And that story is that we had signs of trouble 4 years ago.  Three years ago things went really into the tank.  The economy seriously declined until mid-2009. Ever since then, it’s struggled to hold on.  There really isn’t any recovery.  It’s just going sideways.  We have, in effect, taken a huge chunk of the economy, a huge number of workers, put them on the sideline and said “we’re not interested in you participatin anymore.  We don’t want or need your contribution. We’re happy being smaller”.

So we’ve had monetary stimulus efforts, we’ve had low interest rates, we’ve had the central bank create base money.  There’s plenty of cash out there.  But it’s all in the banks. It’s in deposit accounts. It’s in reserves.  It’s not working. It’s not being used to buy things. It’s not being used for consumption or investment. It’s just sitting around impotent.  That’s a liquidity trap.

Mainstream economic theory, the stuff called “New Classical” or “New Keynesian” (never confuse “New Keynesian” as being “Keynesian”), says keeping interest rates this low for this long would /should fix everything by now.  For over 30 years now, the dominant, orthodox view in the academic and professional world of economists has been that monetary policy exercised by a wise central bank can fix all.  Any weakness in the economy can be solved via lowering interest rates and having the central bank create new bank reserves.  These “modern” theories told us that the concept of a “liquidity trap” was nonsense, a relic of some past era and/or the invention of some crank called Keynes.  These theories claimed that everybody was perfectly rational, all markets (particularly financial markets) were efficient, and uncertainty/risk about the future was unimportant.  They were wrong. We are left with the ideas of the mid-20th century, the stuff that we were told to forget about.  Again Delong:

Four years ago nearly all mainstream economists would have said that, even though the situation appeared serious, by now the economy would be back to normal. …

Very few of us thought that it would be long and nasty…

And as it turned out to be long and nasty, recent economic theories of macroeconomics have fallen like tropical rain forests. The–already implausible–claims that downturns had real causes? Fallen. The claim that downturns lasted only as long as workers misperceived their real wage? Fallen. The claim that the labor market cleared in a small number of years? Fallen. Those of us who believed that the long run came soon, that the cause of downturns was transitory price-level misperceptions, or that downturns had real causes need now to be looking for new jobs, or at least new theories.

And we are left with the live macroeconomic theories being those of the 1960s, at the latest. This is embarrassing for those of us who want to belong to a profession that is a progressive science, rather than an analogue of medieval barbering.

So what would the economic theories of the 1960s and before tell us to do?

  • Milton Friedman: monetary expansion, and more monetary expansion–quantitative easing as deep and as broad as necessary to get nominal GDP back to its trend.
  • John Maynard Keynes (or at least one of the moods of Keynes): have the government borrow and buy stuff, and keep buying stuff until real economic activity is back to some normal trend value.
  • Jacob Viner: Why choose? Do both! Print lots of money and have the government use it to buy stuff and hire people.

The odd thing is that none of those three recommended policies–all of which are sponsored by economists with the purest of purebred pedigrees–have been followed.

It’s time to do two things.  At the policy level we need to go back and try the policies that we understood back in the 50’s and 60’s (economy did pretty well back then, BTW).  Some serious, bold attempts at effective government spending would be nice instead of the weak, too-small, too-timid, niggling efforts dominated by tax cuts we’ve been doing.  And even on the monetary front, it would be more useful to do as Friedman suggested: actually have The Fed keep buying bonds for cash (real circulating money instead of just bank reserves) and keep it up until people start spending it.

On the economics side, we need to get past the perfect rationality and rational expectations stuff (and it’s absurd mathematics) that has dominated the profession.  It would be a good idea to take a more serious look at the heterodox ideas and theories that actually did foresee the crash, the ones based upon realistic models of human behavior and models instead of the perfectly rational, knows-the-future home economicus of the New Classical and New Keynesian models.  We need to seriously look at ideas of Modern Monetary Theorists (MMT), Minsky, the Post-Keynesians, and the behavioral economists.

 

 

There Was No “Stimulus” Spending in Aggregate

One of the claims that Tea Partiers, Republicans, and conservative/neo-liberal economists have been making for some time is that “the stimulus has failed”. They conclude that Keynesian economics and economic policies are failures.  Since, like most claims of Republicans and other politicians, these assertions are usually repeated uncritically by the news media, it’s close to becoming accepted “common wisdom” that the stimulus failed.  It’s not true, though.  What happened is that Keynesian stimulus was never tried.  Yes, U.S. federal government spending temporarily increased for 2 1/2 years.  But the so-called “stimulus” bill of $780 billion passed in Feb 2009 wasn’t all a stimulus spending bill. Much of the money, approx. $380 billion IIRC, was tax cuts.  People didn’t really spend much of those tax cuts because they were paying off debt with the money. That’s not a Keynesian stimulus spending program.  Keynes pointed out that tax cuts are a weaker way of stimulating spending.

But most important is that the additional spending was over 2 1/2 years, and it was only federal spending.  It was completely offset by cuts in spending at the state and local government level.  In aggregate, there was no stimulus spending program. It’s now over anyway.  What people are doing these days is confusing the increased deficit with increased spending, ignoring the fact that the deficit is so big because tax collections are down. Tax collections are down because too many people aren’t working.  And firms won’t hire those people because nobody (including aggregate government) is spending enough.

Paul Krugman notes:

In effect, although without saying so explicitly, the Obama administration has accepted the Republican claim that stimulus failed, and should never be tried again.

What’s extraordinary about all this is that stimulus can’t have failed, because it never happened. Once you take state and local cutbacks into account, there was no surge of government spending. Here’s total (all levels) government spending over the past 10 years:

DESCRIPTION

Looking at this graph, if you didn’t know there had been a “massive” stimulus, would you even have suspected that there had been any stimulus at all?

Who Says Keynesian Policy Doesn’t Work?

It’s become fashionable, particularly among Republicans and Conservatives, to claim that Keynesian Policy doesn’t work despite the empirical record. Methinks they don’t know what Keynesian policies are analyses really are. Mark Thoma points out:

Issa: Everyone Knows That the Policies I Called for Don’t Work

Republican House member Darrell Issa has an op-ed in the Financial Times complaining that the stimulus did not stimulate (contrary to research such as this that finds “programs to support low-income households were highly stimulative, as was spending on infrastructure projects”). He says:

The abysmal results came as no surprise to those who knew that the Keynesian doctrine of spending your way to prosperity had been discredited decades ago.

Than it must of surprised him or, as is more likely, he doesn’t actually know what Keynesian economics is. This is what he said around the time when the stimulus package was put in place. His complaint is that the stimulus package doesn’t come online quickly enough, and doesn’t do enough for infrastructure (he also complains that the tax cuts aren’t permanent):

Economic Stimulus: There is bipartisan agreement for emergency spending on infrastructure and tax cuts that will create new jobs and reinvigorate private sector investments. Unfortunately, H.R. 1, the “American Recovery and Reinvestment Act of 2009,” falls short on both fronts. …

To respond to an emergency, you must act quickly. According to the Congressional Budget Office, only 7 percent of the $355 billion in discretionary spending included in the bill would be injected into the economy by the end of fiscal year 2009. By the end of 2010, only 12 percent of the funds set aside for highway construction will be spent.

Stimulus funds must be targeted to be effective. Only 3 percent of the $825 billion will go toward road and highway construction that creates jobs and aids individuals and private businesses alike. …

This bill will grow the government and miss an opportunity to reinvigorate the economy. An effective stimulus can be accomplished through tax cuts and targeted spending…

Targeted spending and tax cuts are effective stimulus, and he supports them, but we’ve known for decades that such Keynesian remedies don’t work? The mystery of the GOP’s credibility on economics continues…

As an note to the readers:  the economic success of Ronald Reagan’s policies in 1983-1988, following the horrible recession of 1982, are actually better explained and better fit a Keynesian analysis than a the predictions of so-called supply-side models and definitely better than New Classical models.  Reagan was really Keynesian, he just didn’t want to admit it and he preferred military spending and tax cuts for the upper income brackets to social spending.

Tax Cuts Do Not Increase Labor Supply

A central tenet of U.S. “conservative” and Republican economic policy since at least the election of Reagan in 1980 is that tax cuts cause people to work more and longer hours. This is part of the so-called “supply side economics”.  The implication is that the longer hours and more labor supply will then raise the dollars of taxes collected despite the rates being lower, the so-called Laffer Curve effect.

The argument is overly simplistic and fallacious on it’s face. The theoretical support is the one-liner theory idea that “people respond to incentives, take-home money is an incentive to work, and therefore increased take-home pay causes people to work more”. It’s just a version of the retailer’s “cut the price and make it up on volume” logic.  And as such it is dependent on the elasticity of the responses – remember when the response is inelastic, as in “I have to work to live”, the volume won’t be made up.  Despite their being no strong empirical evidence of tax cuts helping raise more tax dollars or motivate widespread increased labor supply at least in the range of real-world tax rates, the concept persists – another Zombie Economics idea.

Dillow adds more to the evidence pile:

Taxes and labour supply: more evidence

Do tax cuts boost labour supply and hence tax revenues? Here’s some evidence that they don’t. Pierre Cahuc and Stephane Carcillo report on an experiment* in France:

The detaxation of overtime hours introduced in October 2007 was intended to allow individuals in France to work more so as to earn more. The evaluation conducted in this article indicates that the detaxation of overtime hours has not, in fact, had any significant impact on hours worked…
Detaxation is a measure costly for the public purse, without any ascertained impact on hours worked.

We can put this alongside the evidence we have for footballers and New York cabbies, which suggests that we are on the positive side of the Laffer curve, where tax cuts do not increase revenues. It’s also consistent with the – very tentative – evidence we have from UK tax receipts this year, which suggests that the introduction of the 50p tax rate has not (yet) reduced revenues.
Now, this is not to deny that Laffer curves exist. No doubt, there is a point at which higher taxes would be counter-productive and tax cuts would pay for themselves. And I’ll concede that it’s possible that the 50p tax rate will, eventually, have adverse effects.
But where is the hard evidence that, at tax rates around current levels, there are such effects? Do the glibertarians  have anything more than prejudice, half a theory, and the post hoc ergo propter hoc fallacy?

Readers and students should note: There is no conflict between these claims and the Keynesian macro-economic policy assertion that tax cuts can stimulate the economy.  The Keynesian policy mechanism works differently.  It asserts that tax  cuts work to widen the budget deficit.  The households spend part of the tax cut while the government continues to maintain it’s other spending. Therefore Aggregate Demand, total spending, in the economy increases. As the spending is received by firms who then pay for labor & resources in the circular flow, the increased spending has a multiplied effect.  The Laffer curve concept is different. It asserts a direct greater willingess-to-work labor supply response.

Myths about Keynesian Policy

From Economicshelp.org:

There are quite a few misunderstandings about Keynesian fiscal policy, two of them include:

  1. Successful fiscal expansion relies on having a war and large military spending. No, fiscal expansion would work much better if it is targeted on public services under provided in a free market, such as: transport, health and education. These maintain AD and improve (rather than destroy) infrastructure.
  2. Fiscal Policy means bigger government. In a boom, governments should be aiming to run budget surplus (or at least very low borrowing). For example, restraining public spending, and not slashing taxes. From a fiscal point of view, in the boom years, it was a mistake to allow UK government spending to grow faster than GDP; in the US it was a mistake to cut income taxes in the boom. The government should have had better finances at the start of 2007, but, we didn’t and you have to deal with what you have.